THE FOREIGN EXCHANGE MARKET
Like most other prices, foreign exchange rates vary from week to week and month to month according to the forces of supply and demand. The foreign exchange market is the market in which currencies of different countries are traded and foreign exchange rates are determined. Foreign currencies are traded at the retail level in many banks and firms specializing in that business. Organized markets in New York, Tokyo, London, and Zurich trade hundreds of billions of dollars worth of currencies each day We can use our familiar supply and marinade curves to illustrate how markets determine the price of foreign currencies. Figure 29-3 shows the supply and demand for U.S. dollars that arise in dealings with japan.” The supply of U.S. dollars comes from people in the United States who need yen to purchase Japanese goods, services, or financial assets. The demand for dollars comes from people in Japan who buy U.S. goods, services, or investment and
who, accordingly, need dollars to pay for these items. The price of foreign exchange-the foreign exchange rate-settles at that price where supply and demand are in balance.
What lies behind the demand for dollars (represented in Figure 29-3 by the DD demand curve for dollar foreign exchange)? Foreigners demand U.S. dollars-when they buy American goods, services, and assets. For example, suppose a Japanese student buys
an American economics textbook or takes a trip to the United States. She will require U.S. dollars to pay for these items. Or when Japan Airlines buys a Boeing 767 for its fleet, this transaction inclines the demand for U.S. dollars. If Japanese funds 111- vest in U.S. Internet stocks, this ,would require a purchase of dollars. Foreigners demand U.S. to j)(I), [or their purchases of American goods, services, find assets.
Market forces move the foreign exchange rate up or down to balance the supply and demand. The price will settle at the- equilibrium foreign exchange rate, which is the rate at which the dollars willingly bought just equal the dollars willingly sold.
We have discussed the foreign exchange market in terms of the supply and demand for dollars. But in this market, there are two currencies involved, so we could just as easily analyze the supply and demand for Japanese yen. To see this, you .,should sketch a supply-and-demand diagram with •. yen foreign exchange on the horizontal axis and the yen rate ($ per ¥) on the vertical axis. If the equilibrium looking from the point of view of the dollar, then $O.OI/¥ is the reciprocal exchange rate. As an exercise, go through the analysis in this section for the reciprocal market. You will see that in this simple bilateral world, for every dollar statement there is an exact yen counterpart: supply of dollars is demand for yen; demand for dollars is supply of yen.
There is just one further extension necessary·to get to actul foreign exchange markets. In reality, there are many different currencies. We therefore need to find the supplies and demands for each and every currency. And in a world of many nations, it is the many-sided exchange and trade, with demands and supplies coming from all parts of the globe, that determines the entire array of foreign exchange rates.
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