Who Determines the Foreign Exchange Rate?

Currency markets today are some of the highest volume trading markets in the world, given the increasingly global and connected nature of the world's economic market. Exchange rates are responsible for the cohesion of these markets. Exchange rates are a function of the aggregate economic activity of many people, and are not set or determined by any one party.

Demand for Foreign Goods

When an American wants to make an economic transaction outside of the United States (for example, importing products from Belgium), he enters the market for foreign exchange to try to obtain foreign currency. The American pays in dollars for units of foreign currency (for our Belgium example, units of euro). In this situation, the American buyer "demands" euros and "supplies" dollars. The exchange rate determines how many dollars the American must give up for how many euros he wants to receive.

Supply of Foreign Currency

When foreigners wish to purchase domestic products (for example, a Frenchman importing American-made machinery), they must trade in foreign currency for dollars. In our example, the Frenchman gives up euros for a quantity of dollars, determined by the exchange rate. In this situation, the French buyer "demands" American dollars and "supplies" euros. The exchange rate determines how many euros the Frenchman must give up for how many dollars he wants to receive.

Supply and Demand

In our two simple examples, a Frenchman gives up euros for dollars and an American gives up dollars for euros. One could imagine, in fact, that this was a personal transaction: The Frenchman gave up some dollars to the American, who traded him some euros. In fact, this is exactly what happens in foreign exchange markets, except that instead of two consumers, there are millions, all of which can trade currencies in the global marketplace with anybody else.

Exchange Rates

Exchange rates occur when both sides of the marketplace for currency come together and make transactions. The forces of aggregate supply and aggregate demand will make the market come to equilibrium, at an exchange rate that equalizes the forces of supply and demand. Exchange rates fluctuate to keep the quantity demanded and the quantity supplied of currency the same--and the relative price of a currency (the exchange rate, or price in terms of other currencies) will be determined entirely by the demand and supply for that currency arising from aggregate economic activity.

Other Exchange Rate Regimes

Exchange rates that are determined by supply and demand are called floating exchange rates, and are the most common type of exchange rate regime today. However, some currencies (especially currencies in the developing world) operate differently. "Pegged" exchange rates are either fixed to some value or adjusted to that value. "Fixed" exchange rates are exchange rates that have a direct convertibility with another currency. However, both of these currency regimes only function because central banking authorities buy and sell currency, as they do not inherently respond to market supply and demand as floating rates do.

References

• Economics: Private & Public Choice, 11th Ed.; Gwartney, Stroup, Sobel, and MacPherson; Thomson South-Western, 2006, [p. 394-401]
• "Expectations and Exchange Rate Dynamics", Dornbusch, Rudiger; The Jounral of Political Economy, V84,N6, (1976)
• "Distinguished Lecture on Economics in Government: Exchange Rate Regimes, Is the Bipolar View Correct?"; Fischer, Stanley; Journal of Economic Perspectives, V15N2, p.3-24 (2001)

Resources

• Bloomberg.com: Benchmark Currency Rates