Dealers and brokers in foreign exchange actually set not one, but two, exchange rates for each pair of currencies. That is, each trader sets a bid (buy) price and an asked (sell) price. The dealer makes a profit on the spread between the bid and asked price, although that spread is normally very small.

2.     Supply and Demand for foreign exchange

The underlying forces that determine the exchange rate between two currencies are the supply and demand resulting from commercial and financial transactions (including speculation). Foreign-exchange supply and demand schedules relate to the price, or exchange rate. This is illustrated in Figure 1, which assumes free-market or flexible exchange rates.

Figure 1

Before examining this figure, we need to define two terms. Depreciation (appreciation) of a domestic currency is a decline (rise) brought about by market forces in the price of a domestic currency in terms of a foreign currency. In contrast, devaluation (revaluation) of a domestic currency is a decline (rise) brought about by government intervention in the official price of a domestic currency in terms of a foreign currency. Depreciation or appreciation is the appropriate concept to deal with floating, or flexible, exchange rates, whereas devaluation or revaluation is appropriate when dealing with fixed exchange rates.

In the dollar-pound exchange market, the demand schedule for pounds represents the demands of U.S. buyers of British goods, U.S. travelers to Britain, currency speculators, and those who wish to purchase British stocks and securi­ties. It slopes downward because the dollar price to U.S. residents of British goods and services declines as the exchange rate declines. An item selling for £1 in Britain would cost $2.00 in the U.S. if the exchange rate were £1/$2.00 U.S. If this exchange rate declined to £1/$1.50 U.S., the same item is $.50 cheaper in the United States, increasing the demand for British goods and thus the demand for pounds. The supply schedule of pounds represents the pounds supplied by British buyers of U.S. goods, British travelers, currency speculators, and those who wish to purchase U.S. stocks and securities. It slopes upward because the pound price to British residents of U.S. goods and services rises as the $ price of the £ falls. Assuming an exchange rate of £1 /$2.00 U.S., a $2.00 item in the U.S. costs £1 in Britain. If this exchange rate declined to £1/$1.50 U.S., the same item is 33 percent more expensive in Britain, decreasing the demand for dollars to buy U.S. goods and thus reducing the supply of pounds. The equilibrium exchange rate in Figure 1 is £1/$2.00 U.S. The amounts supplied and demanded by the market participants are in balance.

Figure 2

To understand better the schedules, several of the factors that might cause these curves to shift are discussed next. If there is a decrease in national income and output in one country relative to others, that nation's currency tends to appreciate relative to others. The domestic income level of any country is a major determinant of the demand for imported goods in that country (and hence a determinant of the demand for foreign currencies). Figure 2 shows the effects of a decline in national income in Britain (assuming all other factors remain constant). The decrease in British income implies a decrease in demand for goods and services (both domestic and foreign) by British people. This reduction in demand for imported goods leads to a reduction in the supply of pounds, which is shown by a leftward shift of the supply curve in Figure 2 (from S to S). If the exchange rate floats freely, the British pound appreciates against the U.S. dollar. If the exchange rate is artifi­cially maintained at the old equilibrium of £1/$2.00 U.S., however, a balance-of-payments surplus (for Britain) likely results.

Figure 3

In Figure 3, an initial exchange-rate equilibrium of £1/$2.00 U.S. is assumed. Now presume the rate of price inflation in Britain is higher than in the United States. British products become less attractive to U.S. buyers (because their prices are increasing faster), which causes the demand schedule for pounds to shift leftward (D to D). On the other hand, because prices in Britain are rising faster than prices in the U.S., U.S. products become more attractive to British buyers, which causes the supply schedule of pounds to shift to the right (S to S). In other words, there is an increased demand for U.S. dollars in Britain. The reduced demand for pounds and the increased supply (resulting from British purchases of U.S. goods) man­dates a newer, lower, equilibrium exchange rate. Furthermore, as long as the inflation rate in Britain exceeded that in the United States, the British pound would continually depreciate against the U.S. dollar.

Differences in yields on various short-term and long-term securities can influence portfolio investments among different countries and also the flow of funds of large banks and multinational corporations. If British yields rise relative to others, an investor wishing to take advantage of these higher interest rates must first obtain British pounds to buy the securities. This increases the demand for British pounds shift the demand schedule in Figure 4 to the right (D to D). British investors are also less inclined to purchase U.S. securi­ties, moving the supply schedule of pounds to the left (S to S). Both activities raise the equilibrium exchange rate of the British pound in terms of U.S. dollars.

Figure 4

3.     Factors affecting foreign exchange rates

·        Balance-of-Payments Position

The exchange rate for any foreign currency depends on a multitude of factors reflecting economic and financial conditions in the country issuing the currency. One of the most important factors is the status of a nation's balance-of-payments position. When a country experiences a deficit in its balance of payments, it becomes a net demander of foreign currencies and is forced to sell substantial amounts of its own currency to pay for imports of goods and services. Therefore, balance-of-payments deficits often lead to price depreciation of a nation's currency relative to the prices of other currencies. For example, during most of the 1970s, 1980s, and into the 1990s, when the United States was experiencing deep balance-of-payments deficits and owed substantial amounts abroad for imported oil, the value of the dollar fell.

·        Speculation

Exchange rates also are profoundly affected by speculation over future currency values. Dealers and investors in foreign exchange monitor the currency markets daily, looking for profitable trading opportunities. A currency viewed as temporarily undervalued quickly brings forth buy orders, driving its price higher vis-a-vis other currencies. A currency considered to be overvalued is greeted by a rash of sell orders, depressing its price. Today, the international financial system is so efficient and finely tuned that billions of dollars can flow across national boundaries in a matter of hours in response to speculative fever. These massive unregulated flows can wreak havoc with the plans of policymakers because currency trading affects interest rates and ultimately the entire economy.

·        Domestic Economic and Political Conditions

The market for a national currency is, of course, influenced by domestic conditions. Wars, revolutions, the death of a political leader, inflation, recession, and labor strikes have all been observed to have adverse effects on the currency of a nation experiencing these problems. On the other hand, signs of rapid economic growth, improving government finances, rising stock and bond prices, and successful economic policies to control inflation and unemployment usually lead to a stronger currency in the exchange markets.

Inflation has a particularly potent impact on exchange rates, as do differences in real interest rates between nations. When one nation's inflation rate rises relative to others, its currency tends to fall in value. Similarly, a nation that reduces its inflation rate usually experiences a rise in the value of its currency. Moreover, countries with higher real interest rates generally experience an increase in the exchange value of their currencies, and countries with low real interest rates usually face relatively low currency prices.

·        Government Intervention

It is known that each national government has its own system or policy of exchange-rate changes. Two of the most important are floating and fixed exchange-rate systems. In the floating system, a nation's monetary authorities, usually the central bank, do not attempt to prevent fundamental changes in the rate of exchange between its own currency and any other currency. In the fixed-rate system, a currency is kept fixed within a narrow range of values relative to some reference (or key) currency by governmental action.

National policymakers can influence exchange rates directly by buying or selling foreign currency in the market, and indirectly with policy actions that influence the volume of private transactions. A third method of influencing exchange rates is exchange control—i.e., direct control of foreign-exchange transactions.

Intervention of a central bank involves purchases or sales of the national money against a foreign money, most frequently the U.S. dollar. A central bank is obliged to prevent its currency from depreciating below its lower support limit. The central bank should buy its own currency from commercial banks oper­ating in the exchange market and sell them dollars in exchange. These trans­actions are effectively an open-market sale using dollar demand deposits rather than domestic bonds. Such transactions reduce the central bank's domestic liabilities in the hands of the public. The ability of a foreign cen­tral bank to prevent its currency from depreciating depends upon its hold­ings of dollars, together with dollars that might be obtained by borrowing. Even if a national monetary authority has the foreign exchange necessary for intervention, its need to support its currency in the exchange market might be inconsistent with its efforts to undertake a more expansive mone­tary policy to achieve its domestic economic objectives.

Also I’d like to say a few words about currency sterilization. A decision by a central bank to intervene in the foreign currency markets will have both currency market and money supply effects unless an operation known as currency sterilization is carried out. Any increase in reserves and deposits that results from a central bank currency purchase can be "sterilized" by using monetary policy tools that absorb reserves. There is currently a great debate among economists as to whether sterilized central bank intervention can significantly affect exchange rates, in either the short term or the long term, with most research studies finding little impact on relative currency prices.

4.     Conclusion

A market in national monies is a necessity in a world of national currencies; this market is the foreign-exchange market. The assets traded in this market are demand deposits denominated in the different currencies. Individuals who wish to buy goods or securities in a foreign country must first obtain that country's currency in the foreign-exchange market. If these individuals pay in their own currency, then the sellers of the goods or securities, use the foreign-exchange market to convert receipts into their own currency.

One from the most important participants of an exchange market is a business bank, which act as the intermediaries between the buyers and sellers. As already it is known they can execute a role speculators and arbitragers.

Most foreign-exchange transactions entail trades involving the U.S. dol­lar and individual foreign currencies. The exchange rate between any two foreign currencies can be inferred as the ratio of the price of the U.S. dollar in terms of each of their currencies.

The exchange rates are prices that equalize the demand and supply of foreign exchange. In recent years, exchange rates have moved sharply, more sharply than is suggested by the change in the relationship between do­mestic price level and foreign price level. Exchange rates do not accurately reflect the relationship between the domestic price level and foreign price levels. Rather, exchange rates change so that the anticipated rates of return from holding domestic securities and foreign securities are the same after adjustment for any anticipated change in the exchange rate.

The major factor influencing to the rate of exchange, is interference of government in the person of central bank in currency policy of the country.  The value of a nation's currency in the international markets has long been a source of concern to governments around the world. National pride plays a significant role in this case because a strong currency, avidly sought by traders and investors in the international marketplace, implies the existence of a vigorous and well-managed economy at home. A strong and stable currency encourages investment in the home country, stimulating its economic development. Moreover, changes in currency values affect a nation's balance-of-payments position. A weak and declining currency makes foreign imports more expen­sive, lowering the standard of living at home. And a nation whose currency is not well regarded in the international marketplace will have difficulty selling its goods and services abroad, giving rise to unemployment at home. This explains why Russia made such stren­uous efforts in the early 1990s to make the Russian ruble fully convertible into other glob­al currencies, hoping that ruble convertibility will attract large-scale foreign investment.

5. Literature used

1.     “Money, banking and the economy”  T. Mayer, J.S. Duesenberry, R.Z. Aliber

W.W. Norton & company   New York, London 1981

2.     “Principles of international finance”  Daniel R. Kane

Croom Helm  1988

3.     “Money and banking”  David R. Kamerschen

College Division South-western Publishing Co.  1992

4.     “Money and capital markets: the financial system in a increasingly global economy”  fifth edition    Peter S. Rose

IRWIN 1994

Summary

A market in national monies is a necessity in a world of national currencies; this market is the foreign-exchange market. The assets traded in this market are demand deposits denominated in the different currencies. Individuals who wish to buy goods or securities in a foreign country must first obtain that country's currency in the foreign-exchange market. If these individuals pay in their own currency, then the sellers of the goods or securities, use the foreign-exchange market to convert receipts into their own currency.

One from the most important participants of an exchange market is a business bank, which act as the intermediaries between the buyers and sellers. As already it is known they can execute a role speculators and arbitragers.

The exchange rates are prices that equalize the demand and supply of foreign exchange. In recent years, exchange rates have moved sharply, more sharply than is suggested by the change in the relationship between do­mestic price level and foreign price level. Exchange rates do not accurately reflect the relationship between the domestic price level and foreign price levels. Rather, exchange rates change so that the anticipated rates of return from holding domestic securities and foreign securities are the same after adjustment for any anticipated change in the exchange rate.

. A strong and stable currency encourages investment in the home country, stimulating its economic development. Moreover, changes in currency values affect a nation's balance-of-payments position. A weak and declining currency makes foreign imports more expen­sive, lowering the standard of living at home. And a nation whose currency is not well regarded in the international marketplace will have difficulty selling its goods and services abroad, giving rise to unemployment at home. This explains why Russia made such stren­uous efforts in the early 1990s to make the Russian ruble fully convertible into other glob­al currencies, hoping that ruble convertibility will attract large-scale foreign investment.

Dictionary