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Lesson summary: the foreign exchange market

AP.MACRO:
MKT‑5.C (LO)
,
MKT‑5.C.1 (EK)
,
MKT‑5.D (LO)
,
MKT‑5.D.1 (EK)
In this lesson summary review and remind yourself of the key terms and graphs related to the market for foreign exchange (FOREX).

Lesson summary

The foreign exchange market is like any other market insofar as something is being bought and sold. However, the foreign exchange market is unique in two ways:
  1. A currency is being bought and sold, rather than a good or service
  2. The currency being bought and sold is being bought with a different currency.

Key Terms

Key termDefinition
exchange ratethe price of one currency in terms of another currency; for example, if the exchange rate for the Euro () is 132 Yen (¥), that means that each Euro that is purchased will cost 132 yen.
foreign exchange marketa market in which one currency is exchanged for another currency; for example, in the market for Euros, the Euro is being bought and sold, and is being paid for using another currency, such as the yen.
demand for currencya description of the willingness to buy a currency based on its exchange rate; for example, as the exchange rate for Euros increases, the quantity demanded of Euros decreases.
appreciatewhen the value of a currency increases relative to another currency; a currency appreciates when you need more of another currency to buy a single unit of a currency.
depreciatewhen the value of a currency decreases relative to another currency; a currency depreciates when you need less of another currency to buy a single unit of a currency.
floating exchange rateswhen the exchange rate of currencies are determined in free markets by the interaction of supply and demand

Key takeaways

Why the demand for a currency is downward sloping

When the exchange rate of a currency increases, other countries will want less of that currency. When a currency appreciates (in other words, the exchange rate increases), then the price of goods in the country whose currency has appreciated are now relatively more expensive than those in other countries. Since those goods are more expensive, less is imported from those countries, and therefore less of that currency is needed.
For example, suppose the price of a cell phone in the U.S. is dollar sign, 400, and the current exchange rate in Japan is 90 ¥ per dollar. That means that it takes: 90, times, dollar sign, 400, equals, 36, comma, 000, ¥ to buy the same cell phone in Japan. If two cell phones are imported into Japan, then a total of 800 US dollars will be needed to buy these phones.
However, if the dollar appreciates so that it now takes 100, ¥ to buy a dollar, the same cell phone now costs 100, times, dollar sign, 400, equals, 40, comma, 000, ¥. Because cell phones are more expensive, only one is imported into Japan from the United States, so the quantity of US dollars that Japan wants will fall from dollar sign, 800, U, S, D to dollar sign, 400, U, S, D.

The equilibrium exchange rate is the interaction of the supply of a currency and the demand for a currency

As in any market, the foreign exchange market will be in equilibrium when the quantity supplied of a currency is equal to the quantity demanded of a currency. If the market has a surplus or a shortage, the exchange rate will adjust until an equilibrium is achieved.
For example, suppose Westeros is a trading partner of Hamsterville, and the currency of Westeros is the Westeros Gold Dragon (W, G, D). Currently, the exchange rate is 20, W, G, D per Hamsterville snark (S, N). At this exchange rate, Hamsterville wants to sell 100, S, N, but Westeros only wants to buy 30, S, N. Therefore, there is a surplus of S, N.
Like any surplus, this will place downward pressure on the price. If the exchange rate is flexible, then the exchange rate will decrease until the quantity supplied is equal to the quantity demanded.

Key Graphical Models

Suppose the United States and Japan are trading partners. Japan’s currency is the Yen (¥) and United States’ currency is the U.S. dollar (U, S, D, dollar sign). We can represent the market for the U.S. Dollar in the foreign exchange market, as shown here:
Figure 1: The foreign exchange market for the U.S. Dollar

Common misperceptions

  • We are used to thinking about buying things with a currency, so many new learners are confused about what the price should be in the market for a currency. Buthe price of an orange is never given in oranges; it’s given in some other currency. Just like an orange, a dollar can’t be bought with itself, but instead it needs to be bought with some other currency.
  • A common misperception is to confuse 1) the things that cause shifts in the supply or demand of a currency with 2) changes in quantity supplied or quantity demanded. To keep this straight, ask yourself “why is this change happening?” If a change is happening in response to a change in the exchange rate, then you are moving along a curve. If a change is happening in response to something else, the entire curve shifts.
  • It might seem like a time saver to take short-cuts on labeling graphs, but this is never a good idea. Take your time labeling the foreign exchange market carefully using the elements of a market:
  • Demand - the demand for the currency that is being exchanged
  • Supply - the supply of the currency that is being exchanged
  • Quantity - the quantity of the currency that is being exchanged
  • Price - some other currency that is being used to buy the currency that is being exchanged

Questions for review

  • China and Ghana are major trading partners. The currency of China is the y, u, a, n and the currency of Ghana is the c, e, d, i. In a correctly labeled graph of the foreign exchange market for the cedi, show the impact of an increase in imports from Ghana to China. Then, explain what is going on in your graph.
  • List 3 things that would cause the exchange rate of the U.S. dollar, in terms of Yen, to increase.

Want to join the conversation?

  • blobby green style avatar for user rfeir
    Why wouldn't the Thai Central Bank want to destroy some of its own currency to reduce the Money Supply?
    (4 votes)
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  • leaf green style avatar for user MeG
    If demand for one currency goes up, does the graph of the other currency always show the supply going up as well?
    (2 votes)
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    • spunky sam blue style avatar for user Cole.Rees
      In general, I think so. If the Chinese demand more American goods or services, they will demand more dollars, shifting demand right, raising the price. They will be more willing to supply Yen for dollars at any price, shifting supply right on the Yen graph, lowering the price of the Yen. Clearly as the Dollar/Yen goes up, the Yen/Dollar must go down, as they are reciprocals.
      (0 votes)
  • blobby green style avatar for user Warda Javed
    What does economist mean in foreign currency market?
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