What Are the Functions of Major Foreign Exchange Markets?

The foreign exchange market, defined by Gwartney as "the market in which the currencies of different countries are bought and sold," is a very important macroeconomic market that functions to even out capital inflows and capital outflows for nations. By using flexible exchange rates, often called "floating" exchange rates, the value of a currency compared to the value of other currencies will fluctuate. These fluctuations are based on demand for the currency and serve to (generally speaking) bring purchases and sales between nations into balance.

Exchange Rates and Fluctuation

Exchange rates, the domestic price of one unit of foreign currency, constantly fluctuate. These fluctuations may seem to occur without reason, but as we shall see, these fluctuations are based on the laws of supply and demand. When foreigners are interested in buying domestic goods and services, they need to acquire domestic currency. To acquire that currency, foreigners enter the market for foreign exchange and seek to trade the foreign currency for domestic currency. As we shall soon see, the aggregate actions of all such interested foreigners (and on the other side of the equation, domestic consumers seeking to import foreign goods and services) determines the exchange rate.

Function of Exchange Rates

Exchange rates function to bring into balance the currency flows to and from a nation. An example of how this process works (of how fluctuation occurs and keeps the economy in equilibrium) is helpful. Imagine that the euro is available to American purchasers at a cost of $1.50 per euro originally, but that all of a sudden, the American people find themselves with more wealth. This could possibly be a result from improving business cycles (a lessening recession, for example). As Americans find themselves with more money, they are likely to be interested in importing from the EU more. As more Americans enter with dollars bills into the foreign currency market, the supply of dollars to foreigners increases, as does the quantity demanded of foreign currency. This will serve to increase the dollar price of the euro, perhaps from $1.50 to $1.80 per euro. Changes like this occur frequently, based on differing rates of inflation, changes in interest rates and changes in income, as well as broader changes in institutional arrangements between nations (much harder to measure).

Foreign Exchange Markets

So the foreign exchange market is characterized by floating exchange rates, which seek to normalize and balance the quantity of foreign exchange demanded by Americans and the supply of dollars to foreigners. In other words, the implications of floating exchange rates can be generally applied: the demand for foreign currencies in replacement of dollars reflects the purchases by Americans of goods and services from foreigners. The foreign exchange markets, then, as a function of market-determined exchange rates, will bring into balance the purchases by domestics of foreign goods and services with the purchases of foreigners of domestic goods and services.

Balance of Payments

The balance of payments is a summary of all economic transactions between a nation and all other nations for a specific time period (often a year). Thanks to fluctuating exchange rates, the foreign exchange market will bring quantity demanded and quantity supplied into balance; in the same way, the market will bring total debits and total credits into balance. This balance of payments must always sum to zero. The balance of payments is made up of two accounts, the capital account and the current account. This explains why the United States typically runs a large trade deficit: the trade deficit is both cause and effect of a strong desire by the rest of the world to invest in American investments in the capital account.

Considerations

Not all exchange rates are free floating, and to the extent that they do not fluctuate according to market theory, they will lead to changes in the balance of payments between nations. Pegged exchange rate systems are those in which a nation would seek to conduct foreign exchange business to achieve a certain exchange rate goal; they can either be successful or unsuccessful, based on the economic salience of the actions of the nation. Fixed exchange rates, on the other hand, will not lead to efficient outcomes as governments try to use tariffs, quotas, restrictions on convertibility of currency and other trade barriers to force the balance of payments to equalize.

References

• "Economics: Private & Public Choice, 11th Ed."; Gwartney, Stroup, Sobel, and MacPherson; Thomson South-Western, 2006
• "Microeconomics, 2nd Ed."; Katz and Rosen; Irwin Series in Economics; 1994