How Does the Currency Market Work?
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Foreign Exchange and Markets
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The market for currency, also known as the foreign exchange market, forex, or FX, is a complex yet important market in the modern economy. The economy works on a global scale, and it is common for transactions to require different currencies and/or transactions between currencies. Any time that goods and services that originate in a country with a different currency are used, currency markets have to operate or the transaction will not go through.
Example
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Imagine that you buy a nice piece of English-made furniture for 1,000 Euros (total cost, including shipping), and you can't wait for it to get to your house. But you don't have any Euros; you only have American dollars. In other words, you demand Euros, because you need them to buy what you want. Meanwhile, a lady in England is trying to buy an American computer for $1,500. She demands dollars, and wants to use her Euros to get them.
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The Currency Market at Work
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Now, imagine that you and the lady in England have a chance to do business. She wants some dollars, and you want Euros; the currency market determines the price of each. If you and her were the only two people in the market, you would be willing to trade your $1,500 for her 1,000 Euros, and therefore the exchange rate between dollars and Euros will be 1.5 dollars = 1 Euro. In other words, the exchange rate between any two currencies is a product of the supply and demand for both of those currencies by the members of both countries. Markets are dynamic. meaning that they change on a constant basis. Unlike in our example, currently trillions of dollars are traded in foreign exchange markets, and the prices for those exchanges are settled by how badly people want certain currencies. For example, if America is experiencing good economic times and is able to return a high rate of return on some of its investments, foreign investors will be eager to acquire dollars and get in on the action, thus making it more costly to acquire dollars for them and making it cheaper for Americans to acquire their currency. Economic conditions in different countries fluctuate constantly, so it is no surprise that the supply and demand for currencies (and therefore exchange rates) fluctuate just as much.
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References
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