foreign exchange

Examples of foreign exchange in the following topics:

• Introducing Exchange Rates

  • In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, or rate) between two currencies is the rate at which one currency will be exchanged for another.
  • Exchange rates are determined in the foreign exchange market, which is open to a wide range of buyers and sellers where currency trading is continuous.
  • The spot exchange rate refers to the current exchange rate.
  • The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency.
  • Explain the concept of a foreign exchange market and an exchange rate

• Exchange Rate Systems

  • An exchange rate regime is how a nation manages its currency in the foreign exchange market.
  • A floating exchange rate, or fluctuating exchange rate, is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market.
  • To ensure that a currency will maintain its "pegged" value, the country's central bank maintain reserves of foreign currencies and gold.
  • They can sell these reserves in order to intervene in the foreign exchange market to make up excess demand or take up excess supply of the country's currency.
  • In dealing with external pressure to appreciate or depreciate the exchange rate (such as interest rate differentials or changes in foreign exchange reserves), the system can meet frequent but moderate exchange rate changes to ensure that the economic dislocation is minimized.

• Finding an Equilibrium Exchange Rate

  • There are two methods to find the equilibrium exchange rate between currencies; the balance of payment method and the asset market model.
  • The balance of payments model holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance.
  • A nation with a trade deficit will experience a reduction in its foreign exchange reserves, which ultimately lowers, or depreciates, the value of its currency.
  • The asset market model views currencies as an important element in finding the equilibrium exchange rate.
  • The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.

• Reason for a Zero Balance

  • Trade within a country differs in one important way from trade between countries: unless the two nations share a common currency, any trade requires that countries go through the foreign exchange market to trade currency, in addition to trading goods and services.
  • This exchange between France and Chile requires that the firms exchange euros for pesos.
  • Exports + (foreign purchases of domestic assets) = imports + (domestic purchases of foreign assets)
  • Exports - imports = (domestic purchases of foreign assets) - (foreign purchases of domestic assets)
  • The financial account is also sometimes used in a narrower sense that excludes the foreign exchange operation of the central bank.

• Exchange Rate Policy Choices

  • A free floating exchange rate increases foreign exchange volatility, which can be a significant issue for developing economies .
  • Flexible exchange rates serve to adjust the balance of trade.
  • When a trade deficit occurs in an economy with a floating exchange rate, there will be increased demand for the foreign (rather than domestic) currency which will increase the price of the foreign currency in terms of the domestic currency.
  • That in turn makes the price of foreign goods less attractive to the domestic market and decreases the trade deficit.
  • The developing countries, marked in light blue, may prefer a fixed or managed exchange rate to a floating exchange rate.

• Real Versus Nominal Rates

  • An exchange rate between two currencies is defined as the rate at which one currency will be exchanged for another.
  • The real exchange rate is the purchasing power of a currency relative to another at current exchange rates and prices.
  • It is the ratio of the number of units of a given country's currency necessary to buy a market basket of goods in the other country, after acquiring the other country's currency in the foreign exchange market, to the number of units of the given country's currency that would be necessary to buy that market basket directly in the given country.
  • If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and price levels of the two countries, and the real exchange rate would always equal 1.
  • In this case, the real A/B exchange rate is 3.

• Fixed Exchange Rates

  • A fixed exchange rate is a type of exchange rate regime where a currency's value is fixed to a measure of value, such as gold or another currency.
  • This is one reason governments maintain reserves of foreign currencies.
  • If the exchange rate drifts too far above the desired rate, the government sells its own currency, thus increasing its foreign reserves.
  • This method is rarely used because it is difficult to enforce and often leads to a black market in foreign currency.
  • China is well-known for its fixed exchange rate.

• Introduction to Monetary Policy

  • In addition, lower interest rates make a currency worth less in the currency exchange market.
  • This reduces the demand for and increases the supply of dollars in the currency market, reducing the exchange rate (in foreign currency per dollar).
  • A lower exchange rate makes a country's goods relatively more affordable for the rest of the world, stimulating exports and further increasing output.
  • The higher interest rate also increases the demand for dollars as foreign investors shift their investments to the United States.
  • Increased demand and decreased supply cause an increase in the exchange rate, which boots imports while reducing exports.

• Managed Float

  • Managed float regimes are where exchange rates fluctuate, but central banks attempt to influence the exchange rates by buying and selling currencies.
  • Some economists believe that in most circumstances floating exchange rates are preferable to fixed exchange rates.
  • Floating exchange rates automatically adjust to economic circumstances and allow a country to dampen the impact of shocks and foreign business cycles.
  • A floating exchange rate is not as stable as a fixed exchange rate.
  • India has a managed float exchange regime.

• The Financial Account

  • This occurs when domestic buyers are purchasing more foreign assets than foreign buyers are purchasing of domestic assets.
  • If a nation's citizens are investing in foreign countries, there is an outbound flow that will count as a deficit.
  • Large short term flows between accounts in different nations are commonly seen when the market is able to take advantage of fluctuations in interest rates and/or the exchange rate between currencies.
  • Purchases of foreign currencies, for example, will increase the deficit and vis versa.
  • Austria has experienced a surplus of foreign direct investment: more foreign investors invest in Austria than Austrian investors do in the rest of the world.