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:
- 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.
Key Terms
Key term | Definition |
---|---|
exchange rate | the price of one currency in terms of another currency; for example, if the exchange rate for the Euro ( |
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 |
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
However, if the dollar appreciates so that it now takes
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 (
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 (
You bet! The nation of Nickelstan uses nickels as their currency. The nation of Cookiestan uses the Cookiestan 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
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.
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
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.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.