B. THE DETERMINATION OF FOREIGN EXCHANGE RATES

FOREIGN EXCHANGE RATES

We are all familiar with domestic trade. When I buy Florida oranges or California computers, I naturally want to pay in dollars. Luckily, the orange grower and the computer manufacturer want payment in U.S. currency, so all trade can be carried out in dollars. Economic transactions within a country are relatively simple.

But suppose I am in the business of selling Japanese bicycles. Here, the transaction becomes more complicated. The bicycle manufacturer wants to be paid in Japanese currency rather than in U.S. dollars. Therefore, in order to import the Japanese bicycles,
I must first buy Japanese yen (¥) and use those yen to pay the Japanese manufacturer. Similarly, if the Japanese want to buy U.S. merchandise, they’ must first obtain U.S. dollars. This new complication involves foreign exchange.

Foreign trade involves the use of different national currencies. The foreign exchange rate is the price of one currency in terms of another currency. The foreign exchange rate is determined in the foreign exchange market, which is the market where different currencies are traded.

Businesses and tourists do not have to know anything more than this for their import or export transactions. But the economics of foreign exchange rates cannot be grasped until we analyze the forces underlying the supply and demand for foreign currencies and the functioning of the foreign exchange market.

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