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 $400\$400, and the current exchange rate in Japan is 90 ¥ per dollar. That means that it takes: 90×$400=36,000¥90 \times \$400 = 36{,}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¥100 ¥ to buy a dollar, the same cell phone now costs 100×$400=40,000¥100 \times \$400 = 40{,}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 $800USD\$800 USD to $400USD\$400 USD.

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 (WGDWGD). Currently, the exchange rate is 20WGD20 WGD per Hamsterville snark (SNSN). At this exchange rate, Hamsterville wants to sell 100SN100 SN, but Westeros only wants to buy 30SN30 SN. Therefore, there is a surplus of SNSN.
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 (USD$USD\$). 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
You bet! The nation of Nickelstan uses nickels as their currency. The nation of Cookiestan uses the Cookiestan Cookie (CCCC) as their currency. Of course, the CC is not an actual cookie, but a round piece of paper with the impression of a cookie.
Nickelstan is a popular vacation destination for the citizens of Cookiestan, and people traveling to Nickelstan need the local currency, the Nickel, to buy things. They go to the foreign exchange market for the Nickel to buy Nickels.
Well, how are they going to pay for these Nickels? Not with Nickels! The are going to trade in their own currency. So the demand for the Nickelstan Nickel is based on countries like Cookiestan wanting to buy Nickels.
The higher the exchange rate (that is, the more CCsCCs it takes to buy a Nickel), the less currency will be demanded. For example, suppose a lime smoothie costs 22 Nickels in Nickelstan, and the current exchange rate is 3CC3 CC per nickel. To the citizens of Cookiestan, a lime smoothie costs 6CC6CC once you account for the exchange rate. If suddenly the exchange rate is 4CC4 CC per nickel, that lime smoothie’s price shot up to 8CC8CC. Suddenly those smoothies don’t seem as appealing, so as people buy less of them, they need fewer Nickels to do so.
Ok, so where does the supply of these Nickels come from? Well, Nickelstanians are also fond of travel and need other countries currencies to buy things abroad. So, Nickelstan will supply their own currency in hopes of trading them in for other currencies.
The interaction of the supply of Nickels and the demand for Nickels will yield an equilibrium exchange rate. The graph illustrates the foreign exchange market for Nickels in equilibrium. Note that cookies are the label for the price of Nickels, because that is how the Nickels are being paid for. Also, note that a nickel is on the quantity label because that is what is being bought.
Figure 2: The market for the Nickelstan Nickel

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 yuanyuan and the currency of Ghana is the cedicedi. 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.
    In order for China to import more goods from Ghana, it will need more cedi to buy Ghanian goods. Therefore, the demand for the cedi will increase. As a result of an increase in the demand for the cedi, the exchange rate of yuan per cedi will increase (in other words, it will take more yuan to buy each cedi).
  • List 3 things that would cause the exchange rate of the U.S. dollar, in terms of Yen, to increase.
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