Foreign Exchange Market Fundamentals
The foreign exchange market, or currency market, facilitates foreign currency and coin transactions between different countries.
Market Exchange: This is where currencies of different countries are bought and sold.
Key Concepts in Currency Exchange
Nominal Exchange Rate
The nominal exchange rate is the relative price of one currency in terms of another. It represents the number of foreign currency units required to obtain one unit of the national currency.
Depreciation of Exchange Rates
Depreciation of exchange rates, for example, a dollar/euro rate reduction, means fewer euros are obtained per dollar.
Appreciation of Exchange Rates
Appreciation of exchange rates, for example, a dollar/euro rate increase, means more euros are obtained per dollar.
Real Exchange Rates
Real exchange rates show the relationship for exchanging goods between one country and another. It is calculated as: E = (Pdomestic * Nominal Exchange Rate) / Pforeign.
Understanding Currency Demand and Supply
Demand for Euros
The demand for euros comes from individuals or organizations wanting to exchange dollars for euros.
Motivations for Euro Demand
- Exports
- American tourists visiting Europe
- Financial capital inflows
Variables Affecting Euro Demand
- The real exchange rate
- Income from abroad
- Interest rate differentials
Euro Demand Curve
The euro demand curve illustrates the inverse relationship between the quantity of euros demanded and the exchange rate, assuming other variables remain constant. As the rate increases, the quantity of euros demanded decreases.
Supply of Euros
The supply of euros comes from individuals or organizations wanting to exchange euros for dollars.
Motivations for Euro Supply
- Imports
- European tourists visiting America
- Financial capital outflows
Variables Affecting Euro Supply
- The real exchange rate
- National income
- Interest rate differential between national and foreign markets
Exchange Rate Systems
Exchange rate systems are sets of rules describing the role of the Central Bank in foreign exchange markets. There are three main types:
- Flexible exchange rates
- Fixed exchange rates
- Mixed systems
Flexible Exchange Rate System
A flexible exchange rate system is determined by the free play of supply and demand and automatically adjusts the balance of payments. It also equates demand and supply in the exchange market, making central bank intervention unnecessary for external equilibrium.
Fixed Exchange Rate System
In a fixed exchange rate system, the central bank sets a specific value for its currency relative to another currency or a basket of currencies. It intervenes in the currency market to maintain the exchange rate at the set level.
Mixed Exchange Rate System
A mixed exchange rate system allows the exchange rate to fluctuate freely within fixed boundaries. The monetary authority’s intervention cannot exceed or fall below these limits. When the rate exceeds these limits, it behaves like a fixed exchange rate system, leading to identical effects: increases or decreases in foreign reserves and balance of payments disequilibrium.
Exchange Rate Adjustments
Appreciation
Appreciation is a rising exchange rate in a flexible exchange rate system.
Revaluation
Revaluation is a situation where the central bank increases the official exchange rate in a fixed rate system.
Depreciation
Depreciation is a reduction of the exchange rate in a flexible rate system.
Devaluation
Devaluation is a situation where the central bank reduces the official exchange rate in a fixed rate system.
European Monetary Union (EMU)
Adoption of Monetary Union
The adoption of monetary union implies a loss of autonomy for member states regarding monetary policy, as exchange policy becomes the responsibility of the community organization.
Fundamentals and Advantages of EMU
Objectives of EMU
- Exchange rate stability
- Coordination and control of monetary policy
- Fiscal discipline
- Creation of the European Central Bank
- Establishment of a single currency (Euro)
Stability and Growth Pact
The Stability and Growth Pact represents a commitment to budgetary stability, though its application allows for some flexibility. Budgetary equilibrium must be achieved cyclically.