Unit 7 Mechanics of the Foreign Exchange (FOREX) [5-3-16]

Unit 7

Mechanics of the Foreign Exchange (FOREX)

•  The buying and selling of currency. 

•  Any transaction that occurs in the balance of payments necessitates foreign exchange.

•  The exchange rate (e) is determined in the foreign currency markets.

 Changes in exchange rates

•   Exchange rates (e) are a function of the supply and demand for currency. 

•   An increase in the supply of a currency will decrease the exchange rate of a currency. 

•   A decrease in supply of a currency will increase the exchange rate of a currency.

•   An increase in demand for a currency will increase the exchange rate of a currency.

•   A decrease in demand for a currency will decrease the exchange rate of a currency

Appreciation and depreciation

•        Appreciation of a currency occurs when the exchange rate of that currency increases. (e increases)
•        Depreciation of a currency occurs when the exchange rate of that currency decreases (e decreases)

Determinants of Exchange rate

1.      Consumer tastes (buyers taste)

2.      Relative income

3.      Relative price level

4.      Speculation

Exports and imports
The exchange rate is a determinant of both exports and imports.

·         Appreciation of the dollar causes American goods to be relatively more expensive and foreign goods to be relatively cheaper, thus reducing exports and increasing imports.

·         Depreciation of the dollar causes American goods to be relatively cheaper and foreign goods to be relatively more expensive, thus increasing exports and reducing imports.

As two currencies trade:
1.      One supply line will change; the other demand line will change.

2.      They will move in the same direction.

3.      One currency will appreciate, the other will depreciate.

Flexible rate
Based on the supply and demand of that currency versus the other currency. It is very sensitive to the business cycle and it provides options for investment.

Fixed rates
It is based on a countries willingness to distribute currency and to control the amount.