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Foreign Exchange Markets Summary

Domestic residents in an open economy often have dealings with international transactions. American car dealers, for example, buy Japanese Toyotas and Datsuns, while German computer companies sell electronic notebooks to Mexican businessmen. Similarly, Australian mutual funds invest in the shares of companies all over the world, while the treasurer of a Canadian transnational corporation parks idle cash in 90-day Bank of England notes. Most of these transactions require one or more participants to acquire a foreign currency. If an American buys a Toyota and pays the Japanese Toyota dealer in dollars, for example, the latter will have to exchange the dollars for yens in order to have the local currency with which to pay his workers and local suppliers (Douglass, 2002).



The foreign exchange market is the market in which national currencies are traded. As in any market, a price must exist at which trade can occur (Douglass, 2002). An exchange rate is the price of a unit of domestic currency in terms of a foreign currency. Therefore, if the exchange rate of the dollar in terms of the Japanese yen increases, we say the dollar has depreciated and the yen has appreciated. Similarly, a decrease in the dollar/yen exchange rate would imply an appreciation of the dollar and a depreciation of the yen.



The world has a few major foreign currency exchange markets. These are the freely floating exchange rates, fixed rate currency exchange markets, and managed or float, also known as dirty. Each one has there advantages and disadvantages and we will cover these issues now.



The freely floating exchange rates tend to respond quickly to shifts in the currency market. Therefore, it's easier to watch and predict. Because of this quick response time, excess demand or excess supplies are quickly eliminated by rate adjustments in the currency market. This makes for a much more controllable market. However, freely floating exchange rates are not...