6.2 - THE FOREIGN EXCHANGE MARKET
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Introduction to the Foreign Exchange Market
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Today, we will explore the Foreign Exchange Market and understand its fundamental role in the global economy. Can anyone tell me what the Foreign Exchange Market is?
Is it where currencies are bought and sold?
Exactly! The Foreign Exchange Market is a marketplace where national currencies are traded. Major participants include commercial banks, brokers, and monetary authorities. Remember the acronym CBM for Commercial Banks, Brokers, and Monetary Authorities. Who can tell me the significance of exchange rates?
They help us know how much of our currency we need to exchange to buy foreign currency?
Precisely! Exchange rates facilitate international trade by letting us know how much domestic currency is needed for foreign transactions.
Demand and Supply for Foreign Exchange
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Now, let’s look at what drives demand and supply for foreign exchange. Can someone give examples of why people demand foreign currency?
To buy products from other countries?
Yes! It's primarily for purchasing international goods and services. Demand decreases when foreign currency prices rise—this causes a reduction in imports. Now, how about supply? What factors contribute to the supply of foreign exchange?
When we export goods and services!
Great! Supply increases through exports and foreign investments, and we see how both demand and supply interact to determine exchange rates.
Types of Exchange Rate Systems
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Next, let's talk about how exchange rates can be classified. We have fixed rates, flexible rates, and managed floating rates. Can anyone explain what a fixed exchange rate is?
It’s when the government sets the value of the currency to a certain level?
Correct! In a fixed system, governments intervene to maintain rates. What about flexible exchange rates—who can summarize that?
Those are determined by market forces without government intervention.
Spot on! Lastly, managed floating is a mix of both—where the market primarily decides, but the government may step in if necessary.
Factors Influencing Exchange Rates
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For our final session today, let's look at how external factors influence exchange rates. Can anyone tell me how interest rates might affect exchange rates?
Higher interest rates attract foreign investments, which increases demand for that currency?
Exactly! Higher interest rates can increase demand, which can appreciate the currency. Now about inflation, how does that play into exchange rates?
If inflation is higher in one country, its currency may depreciate compared to others?
Right! Inflation makes goods more expensive, affecting the currency's value. Lastly, let’s remember purchasing power parity from earlier in our discussion; it helps in understanding long-term exchange rate relationships by comparing the price of the same goods across countries.
Introduction & Overview
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Quick Overview
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This section explores the Foreign Exchange Market's role in determining currency values, the factors influencing demand and supply, and the differences between fixed, flexible, and managed exchange rate systems.
Detailed
Detailed Overview of The Foreign Exchange Market
The Foreign Exchange Market plays a critical role in the global economy, facilitating transactions involving different national currencies. Participants like commercial banks and brokers operate in this market to trade currencies, which determines the exchange rate— the price of one currency in terms of another.
The exchange rate determines how much domestic currency is needed to purchase foreign currencies and vice versa, affecting international trade and investment.
Key participants in this market include:
1. Commercial Banks: Facilitate currency transactions for clients.
2. Foreign Exchange Brokers: Assist in the buying and selling of currencies.
3. Monetary Authorities: Central banks that may intervene in currency trading to stabilize or influence their currency's value.
Demand for Foreign Exchange arises due to:
1. Importing goods and services.
2. Sending remittances or gifts abroad.
3. Purchasing foreign financial assets.
Supply of Foreign Exchange increases when:
1. Exports of goods and services occur.
2. Foreigners send gifts to domestic residents.
3. Foreigners purchase domestic financial assets.
The exchange rate can be categorized under three systems:
1. Flexible Exchange Rate: Determined by market forces; it fluctuates based on supply and demand.
2. Fixed Exchange Rate: Set deliberately by a government, which may require intervention to maintain.
3. Managed Floating Exchange Rates: A blend of both; market forces primarily determine rates, but the government intervenes to stabilize currency fluctuations.
The exchange rate impacts international trade, with higher rates potentially decreasing imports while boosting exports, depending on factors like interest rates, inflation, and purchasing power parity (PPP). This understanding is vital for grasping how globalization affects national economies.
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Introduction to the Foreign Exchange Market
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So far, we have considered the accounting of international transactions on the whole, we will now take up a single transaction. Let us assume that a single Indian resident wants to visit London on a vacation (an import of tourist services). She will have to pay in pounds for her stay there. She will need to know where to obtain the pounds and at what price. As mentioned at the beginning of this chapter, this price is known as the exchange rate. The market in which national currencies are traded for one another is known as the foreign exchange market.
Detailed Explanation
This chunk introduces the concept of the foreign exchange market, which facilitates the exchange of one currency for another. It highlights a practical scenario where an Indian resident needs to exchange rupees for pounds to pay for services in London. The 'exchange rate' is underscored as a critical concept, representing the price at which currencies can be traded.
Examples & Analogies
Think of the foreign exchange market like a currency exchange booth at an airport where travelers exchange their money to different currencies based on certain rates. For instance, if you travel from India to England, you need to convert your rupees into pounds at the exchange rate set by the market.
Participants in the Foreign Exchange Market
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The major participants in the foreign exchange market are commercial banks, foreign exchange brokers and other authorised dealers and monetary authorities. It is important to note that although participants themselves may have their own trading centres, the market itself is world-wide. There is a close and continuous contact between the trading centres and the participants deal in more than one market.
Detailed Explanation
In this chunk, the main players in the foreign exchange market are identified as commercial banks, brokers, and monetary authorities. These participants are interconnected and operate globally, allowing for seamless trading across different locations. Understanding who these participants are helps clarify how exchange rates are formed and how transactions occur.
Examples & Analogies
Imagine a bustling marketplace where different vendors (commercial banks and brokers) sell their goods (currencies). Just as vendors communicate and trade among themselves to offer the best price for their items, the participants in the foreign exchange market continuously interact to provide competitive exchange rates for currencies.
Understanding Foreign Exchange Rate
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Foreign Exchange Rate (also called Forex Rate) is the price of one currency in terms of another. It links the currencies of different countries and enables comparison of international costs and prices. For example, if we have to pay Rs 50 for $1 then the exchange rate is Rs 50 per dollar.
Detailed Explanation
This chunk defines the foreign exchange rate, explaining it as the price at which one currency can be exchanged for another. The example given illustrates how the exchange rate provides a foundation for comparing costs between countries. Understanding this concept is crucial for anyone engaging in international transactions.
Examples & Analogies
Consider a shop that sells goods from different parts of the world. If a toy costs $1 in the US and $50 in India, the exchange rates would help determine where it is cheaper to buy. The exchange rates act like a price tag for converting currencies!
Demand for Foreign Exchange
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People demand foreign exchange because: they want to purchase goods and services from other countries; they want to send gifts abroad; and, they want to purchase financial assets of a certain country. A rise in price of foreign exchange will increase the cost (in terms of rupees) of purchasing a foreign good. This reduces demand for imports and hence demand for foreign exchange also decreases, other things remaining constant.
Detailed Explanation
Here, we explore why individuals and businesses demand foreign exchange. The need arises from various activities such as buying imported goods, sending gifts overseas, or investing abroad. If the cost of foreign exchange rises, it can make imports more expensive, thus reducing demand for foreign items.
Examples & Analogies
Think of planning a birthday party where you want to invite friends from different parts of the world. If it costs too much to send invitations (foreign exchange gets expensive), you might decide to send digital cards instead, reducing your need to exchange currency.
Supply of Foreign Exchange
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Foreign currency flows into the home country due to the following reasons: exports by a country lead to the purchase of its domestic goods and services by the foreigners; foreigners send gifts or make transfers; and, the assets of a home country are bought by the foreigners.
Detailed Explanation
This chunk discusses the reasons why foreign currency enters a country—primarily through exports, foreign gifts, and investments. Awareness of how supply is generated offers a more complete perspective on how the foreign exchange market operates and affects the currency value.
Examples & Analogies
Imagine you're selling handmade crafts internationally. Every time someone abroad buys your crafts, they pay in their local currency, giving you foreign currency in return. This is how your local market gets more foreign exchange, allowing you to buy things from abroad.
Exchange Rate Determination
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Different countries have different methods of determining their currency’s exchange rate. It can be determined through Flexible Exchange Rate, Fixed Exchange Rate or Managed Floating Exchange Rate.
Detailed Explanation
This chunk introduces various systems under which exchange rates are determined. It emphasizes that each country employs a method based on its economic objectives, stability needs, and market conditions. Knowing these systems is essential for understanding how and why exchange rates change.
Examples & Analogies
Picture a board game where the rules change based on players’ strategies. Just like players might decide to stick with one set of rules or adapt as they play, countries choose how to manage their exchange rates based on their economic priorities.
Flexible Exchange Rates
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This exchange rate is determined by the market forces of demand and supply. It is also known as Floating Exchange Rate. As depicted in Fig. 6.1, the exchange rate is determined where the demand curve intersects with the supply curve, i.e., at point e on the Y-axis.
Detailed Explanation
Flexible exchange rates are determined by supply and demand in the market; they fluctuate based on these forces. This balance point, where demand equals supply, illustrates how easily market changes can impact currency values. It explains why currencies can appreciate or depreciate rapidly based on economic news.
Examples & Analogies
Think of a popular concert ticket. If everyone wants to go, the ticket prices will soar due to high demand. Similarly, a currency's value can rise or fall quickly based on how many people want to buy or sell it in the marketplace.
Impact of Supply and Demand on the Exchange Rate
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Suppose the demand for foreign goods and services increases (for example, due to increased international travelling by Indians), then as depicted in Fig. 6.2, the demand curve shifts upward and right to the original demand curve. This indicates that the value of rupees in terms of dollars has fallen and the value of dollars in terms of rupees has risen.
Detailed Explanation
When demand for foreign goods increases, it results in a shift in the demand curve for foreign currency. This causes the value of the domestic currency to depreciate, which means that more of that currency is needed to purchase the same amount of foreign currency. Understanding this impact is essential for both businesses and consumers.
Examples & Analogies
Imagine you're at a shopping mall trying to buy foreign snacks. As more shoppers flood in wanting the same snacks, the prices go up. The same concept applies to currencies—higher demand leads to a higher cost to obtain foreign money to make purchases.
Speculation and the Exchange Rate
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If Indians believe that the British pound is going to increase in value relative to the rupee, they will want to hold pounds. Thus exchange rates also get affected when people hold foreign exchange on the expectation that they can make gains from the appreciation of the currency.
Detailed Explanation
Speculation involves buying currency based on anticipated value changes. If traders expect a currency to increase in value, they will buy it, which can drive the exchange rate higher due to increased demand. This speculative behavior is common and can have significant effects on the market.
Examples & Analogies
Think of investing in a popular stock that everyone thinks will rise soon. If enough people buy that stock, its price continues to go up, reinforcing the belief that it’s a worthy investment. Similarly, when many believe a foreign currency will gain value, its demand increases, driving up its exchange rate.
Factors Influencing Exchange Rate Movements
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In the short run, another factor that is important in determining exchange rate movements is the interest rate differential i.e. the difference between interest rates between countries. There are huge funds owned by banks, multinational corporations and wealthy individuals which move around the world in search of the highest interest rates.
Detailed Explanation
This chunk highlights interest rate differentials as a critical factor in currency valuation. Investors will seek currencies of countries with higher yield potential, leading to increased demand for those currencies. Understanding this behavior can provide insights into exchange rate fluctuations.
Examples & Analogies
It's like shopping for the best deal. If one store offers significantly more discount coupons than another, customers flock to that store. Likewise, investors gravitate towards currencies that yield higher returns, increasing their value relative to others.
Income and Its Effect on Exchange Rate
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When income increases, consumer spending increases. Spending on imported goods is also likely to increase. When imports increase, the demand curve for foreign exchange shifts to the right.
Detailed Explanation
As people's incomes rise, they tend to buy more goods, including foreign goods. This increased demand for imports shifts the demand curve for foreign currencies upward, potentially depreciating the domestic currency. An understanding of this concept is vital for predicting how changes in consumer behavior can impact exchange rates.
Examples & Analogies
Imagine a person receiving a bonus at work. They decide to splurge on luxury items from abroad. This sudden influx of spending increases demand for foreign currency, just as a higher paycheck empowers consumers to buy more.
Long-Run Implications of Exchange Rates
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The purchasing Power (PPP) theory is used to make long-run predictions about exchange rates in a flexible exchange rate system. According to the theory, as long as there are no barriers to trade like tariffs (taxes on trade) and quotas (quantitative limits on imports), exchange rates should eventually adjust so that the same product costs the same whether measured in rupees in India or dollars in the US.
Detailed Explanation
This chunk discusses the Purchasing Power Parity (PPP) theory, which suggests that in the long run, exchange rates will adjust until identical goods have the same price across different currencies, assuming no trade barriers. Understanding this helps to anticipate long-term currency movements and inflation impacts.
Examples & Analogies
Think of a standard coffee cup. If it costs $2 in the US and ₹100 in India, and if no extra costs are involved in production or transportation, over time, adjustments will occur until both prices match, reflecting the true purchasing power of each currency.
Types of Fixed Exchange Rates
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Fixed exchange rate is an exchange rate between the currencies of two or more countries that is fixed at some level and adjusted only infrequently. Governments may intervene to maintain these rates.
Detailed Explanation
Fixed exchange rates are established by governments and only change occasionally, usually through intervention. This provides stability but can lead to issues like currency speculation if there’s uncertainty about the government's ability to maintain the rate. This understanding is vital for those predicting exchange movements.
Examples & Analogies
Think of a fixed-rate mortgage where the payment amount doesn’t change after signing. This fixed nature provides predictable costs over time, similar to how a government’s fixed exchange rate can create stability in international trade for a period.
Advantages and Disadvantages of Fixed vs Flexible Rates
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The main feature of the fixed exchange rate system is that there must be credibility that the government will be able to maintain the exchange rate at the level specified. Often, if there is a deficit in the BoP, in a fixed exchange rate system, governments will have to intervene to manage the gap using official reserves.
Detailed Explanation
This section contrasts fixed exchange rates with flexible rates, discussing credibility and intervention. A fixed rate requires a solid commitment from the government to maintain it, while flexible rates offer more adaptability to market changes. This comprehension helps in understanding how different systems react to economic conditions.
Examples & Analogies
Consider a ship sailing in calm waters (fixed rate) versus navigating through storms (flexible rate). The ship must maintain balance under fixed conditions while being able to adapt when rough seas arise in a flexible system.
Managed Floating Exchange Rate
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Without any formal international agreement, the world has moved on to what can be best described as a managed floating exchange rate system. It is a mixture of a flexible exchange rate system and a fixed rate system.
Detailed Explanation
The managed floating exchange rate system combines elements of both flexibility and government control. Central banks step in to stabilize the currency when necessary, meaning exchange rates can fluctuate while still providing oversight. This hybrid approach is important for countries looking to balance market forces with stability.
Examples & Analogies
Think of a well-trained swimmer who dives into different depths (flexible rate) but is also tethered to a lifeguard on standby. The lifeguard intervenes when necessary to keep the swimmer safe, representing how central banks act in the managed floating system.
Key Concepts
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Foreign Exchange Market: A marketplace where currencies are traded.
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Exchange Rate: The price of one currency compared to another currency.
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Demand for Foreign Exchange: A measure of the need for a foreign currency.
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Supply of Foreign Exchange: The influx of foreign currency into a domestic market.
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Flexible Exchange Rate: Determined by the market's dynamics.
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Fixed Exchange Rate: Set by government action.
Examples & Applications
If the exchange rate is Rs 50 per $1, an Indian needing to buy a $100 item would need Rs 5000.
A depreciation of the rupee means it now costs Rs 70 to buy $1, making imports from the US more expensive for Indian consumers.
Memory Aids
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Rhymes
When dollars we need, to exchange must we heed. To foreign land we plan, by trade we understand.
Stories
Imagine Sarah wants to buy a toy from the US, so she needs dollars. She checks the exchange rate—today it’s fifty rupees for a dollar and knows she must convert her money wisely to buy her desired toy.
Memory Tools
DEMAND stands for: D - Dollars, E - Exports, M - Money, A - Assets, N - Needs, D - Demand!
Acronyms
FRIED for Foreign Exchange
- Flexible Rate
- Real Dynamics
- Interest impacts
- Exports boost
- Demand grows.
Flash Cards
Glossary
- Exchange Rate
The price of one currency in terms of another.
- Flexible Exchange Rate
An exchange rate determined by market forces of supply and demand.
- Fixed Exchange Rate
An exchange rate that is maintained at a certain level by government intervention.
- Managed Floating Exchange Rate
An exchange rate system where the market primarily determines exchange rates, but the government intervenes as necessary.
- Demand for Foreign Exchange
The need for foreign currency for purchasing goods, services, gifts, or financial assets abroad.
- Supply of Foreign Exchange
The influx of foreign currency resulting from exports, foreign investment, and other transactions.
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