Foreign exchange market

Exchange Rate

In the Foreign Exchange Market, we exchange the currency of one country for the currency of another.

Why? A person from Japan might want to travel to the US. So, in order to buy goods and services (exports), they would need US dollars instead of yen. Others might want to buy bonds, stocks, or simply hold US dollars in a US bank.

In the Foreign Exchange Market, we use have some terminologies:

1. Foreign Currency: the money of other countries regardless if the money are notes, coins or bank deposits.
2. Foreign Exchange Brokers: a person who buys and sells currencies for clients while charging a commission for their service
3. Exchange Rate: the price of exchanging one currency for another in the foreign exchange market.
   
   Example: $1 US could be exchanged for 6.78 Yuan in May 7, 2019. So, the exchange rate is 6.78 Yuan per US dollar.
   
   The exchange rate changes over time. It can either appreciation, depreciate or say the same.
   1. Appreciation means exchange rate $\, \uparrow$.
   2. Depreciation means exchange rate $\, \downarrow$

The Foreign Exchange Market has a demand and a supply. The demand for one currency is the supply of another currency. If you have US dollars and you are exchanging for yuan, then you are demanding yuan by supplying US dollars.

Note: The Foreign Exchange Market is a competitive market. This means demand and supply determines the price. So, we will have to look at the demand curve and supply curve to see what the exchange rate is.

Demand Curve in the Foreign Exchange Market

The law of demand for foreign exchange says the following:

1. When exchange rate$\, \uparrow$ then quantity demanded for US dollars $\, \downarrow$
2. When exchange rate$\, \downarrow$ then quantity demanded for US dollars $\, \uparrow$

How does the exchange rate influence the demand for US dollars?

1. Exports Effect: The bigger the value of US exports, the more quantity demanded for US dollars. However, the value of the US exports must depend on the price of US goods and services (that are expressed in the currency of the foreign buyer). So,
   1. exchange rate $\, \downarrow \,$→$\,$ price of US goods and services for foreigners $\, \downarrow \,$→$\,$ exports $\, \uparrow \,$→$\,$ demand for US dollars $\, \uparrow \,$.
   2. exchange rate $\, \uparrow \,$→$\,$ price of US goods and services for foreigners $\, \uparrow \,$→$\,$ exports $\, \downarrow \,$→$\,$ demand for US dollars $\, \downarrow \,$.
2. Expected Profit Effect: People gain profit from holding US dollars today and selling in the future.
   1. Exchange rate today $\, \downarrow \,$→$\,$ expected profit $\, \uparrow \,$→$\,$ quantity demanded for US dollar $\, \uparrow \,$.
   2. Exchange rate today $\, \uparrow \,$→$\,$ expected profit $\, \downarrow \,$→$\,$ quantity demanded for US dollar $\, \downarrow \,$.

The relationship between the quantity demanded for US dollar and exchange rate gives us the following demand curve:




Supply Curve in the Foreign Exchange Market

The law of supply for foreign exchange says the following:

1. When exchange rate $\, \uparrow \,$, then quantity supplied for US dollars $\, \uparrow \,$
2. When exchange rate $\, \downarrow \,$, then quantity supplied for US dollars $\, \downarrow \,$

How does the exchange rate influence the supply for US dollars?

1. Import Effect: The bigger the value of US imports, the more quantity supplied for US dollars. However, the value of the US imports must depend on the price of foreign goods and services (that are expressed in US dollars). So,
   1. Exchange rate $\, \uparrow \,$→$\,$ price of foreign goods and services $\, \downarrow \,$→$\,$ imports $\, \uparrow \,$→$\,$ supply for US dollars $\, \uparrow$ .
   2. Exchange rate $\, \downarrow \,$→$\,$ price of foreign goods and services $\, \uparrow \,$→$\,$ imports $\, \downarrow \,$→$\,$ supply for US dollars $\, \downarrow$.


2. Expected Profit Effect: People gain profit from selling US dollars today and hold foreign currencies.
   1. Exchange rate today $\, \uparrow \,$→$\,$ expected profit $\, \uparrow \,$→$\,$ quantity supplied for US dollar $\, \uparrow$ .
   2. Exchange rate today $\, \downarrow \,$→$\,$ expected profit $\, \downarrow \,$→$\,$ quantity supplied for US dollar $\, \downarrow$.

The relationship between the quantity supplied for US dollar and exchange rate gives us the following supply curve:




Foreign Exchange Market Equilibrium

Combining the demand and supply curve gives us the following graph.



The intersection of the two curves is where the quantity supplied is equal to the quantity demanded for US dollars and gives us the equilibrium exchange rate.

Case 1: The exchange rate is above the equilibrium exchange rate.



In this case, there will be a surplus of US dollars supplied. Since there are too many US dollars in the market needed to be exchanged, the US dollars become cheaper. This decreases the exchange rate until it reaches the equilibrium exchange rate.

Case 2: The exchange rate is below the equilibrium exchange rate.



In this case, there will be a shortage of US dollars supplied. Since there are too little US dollars in the market needed to be exchanged, the US dollars become more expensive. This increases the exchange rate until it reaches the equilibrium exchange rate.