Foreign Exchange Market

Buying and selling of currency

• In order to purchase souvenirs in France, first necessary for Americans to sell (supply) their dollars and buy (demand) Euros
• Exchange rate (e) is determined in the foreign currency markets and is the price of a currency
• Change the demand on one currency graph, change the supply on the other currency graph
• Move the lines on the two currency graphs in the same direction and you will have the correct answer
• If D increases on one graph, S increases on the other

Changes in Exchange Rates

• Exchange rates (e) are a function of the supply and demand for currency
• increase in supply of currency will make it cheaper to buy one unit of that currency
• decrease in supply of currency will make it more expensive to buy one unit of that currency
• increase in demand for a currency will make it more expensive to buy one unit of that currency
• decrease in demand for a currency will make it cheaper to buy one unit of that currency

1. Appreciation of a currency occurs when the exchange rate of that currency increases
2. Depreciation of a currency occurs when the exchange rate of that currency decreases

Purchasing Power Parity

• When the currency rates are set by international markets, changes will be based on the actual purchasing power of the currencies
• Ex.: If the US dollar to the European euro rate is 1.5 to 1, then each $1.50 will buy 1 euro. However, if an item in the US costs $1.50 and then costs more or less than 1 euro, the parity is lost. Markets will adjust quickly in floating rate or pressure for change will occur in fixed rates
• What is the need for exchanging currencies?
• Sell exports, buy immports
• Invest in other countries stocks and bonds
• build factory or store in other markets
• speculate on currency values
• hold currencies in bank acct. for future exports, imports and business loans
• to control excessive imbalances