Mechanics of Foreign Exchange (FOREX)

FOREX

The buying and selling of currency 

• ex. In order to purchase souvenirs in France, it is first necessary for Americans to seek their dollars and buy euros 
• 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 e

e are a function of the supply and demand for currency 

• an increase in the supply of a currency will decrease the e of currency 
• A decrease in supply of a currency will increase the e of a currency
• An increase in demand for a currency will increase the e of a currency 
• A decrease in the demand for a currency will decrease the e of a currency 

Appreciation and depreciation

• appreciation of a currency occurred when the e of that currency increases
• Depreciation occurs when the e of that currency decreases 

Exchange rate determinants

• consumer tastes 
• Relative income 
• Relative price level
• Speculation 

Exports and imports

• the e 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 caused American goods to be relatively cheaper and foreign goods to be relatively more expensive thus increasing exports and reducing imports 

Floating or flexible rates 

• depends upon supply and demand for that currency vs other currencies 
• Very sensitive to the business cycle
• Provides options for investments 

Fixed rate

• based upon a countries willingness to distribute currency and the ability to control the amounts