Lesson summary: the foreign exchange market
- A currency is being bought and sold, rather than a good or service
- The currency being bought and sold is being bought with a different currency.
|exchange rate||the 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 market||a 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 currency||a 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.|
|appreciate||when 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.|
|depreciate||when 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 rates||when the exchange rate of currencies are determined in free markets by the interaction of supply and demand|
Why the demand for a currency is downward sloping
The equilibrium exchange rate is the interaction of the supply of a currency and the demand for a currency
Key Graphical Models
- 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 and the currency of Ghana is the . 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.