15.1 How the Foreign Exchange Market Works

In the foreign exchange market, people and firms exchange one currency to purchase another currency. The demand for dollars comes from those U.S. export firms seeking to convert their earnings in foreign currency back into U.S. dollars; foreign tourists converting their earnings in a foreign currency back into U.S. dollars; and foreign investors seeking to make financial investments in the U.S. economy. On the supply side of the foreign exchange market for the trading of U.S. dollars are foreign firms that have sold imports in the U.S. economy and are seeking to convert their earnings back to their home currency; U.S. tourists abroad; and U.S. investors seeking to make financial investments in foreign economies. When currency A can buy more of currency B, then currency A has strengthened or appreciated relative to currency B. When currency A can buy less of currency B, then currency A has weakened or depreciated relative to currency B. If currency A strengthens or appreciates relative to currency B, then currency B must necessarily weaken or depreciate with regard to currency A. A stronger currency benefits those who are buying with that currency and injures those who are selling. A weaker currency injures those, like importers, who are buying with that currency and benefits those who are selling with it, like exporters.

15.2 Demand and Supply Shifts in Foreign Exchange Markets

In the extremely short term, ranging from a few minutes to a few weeks, exchange rates are influenced by speculators who are trying to invest in currencies that will grow stronger and to sell currencies that will grow weaker. Such speculation can create a self-fulfilling prophecy, at least for a time, where an expected appreciation leads to a stronger currency, and vice versa. In the relatively short term, exchange rate markets are influenced by differences in rates of return. Countries with relatively high real rates of return, for example, high interest rates, will tend to experience stronger currencies as they attract money from abroad, whereas countries with relatively low rates of return will tend to experience lower exchange rates as investors convert to other currencies.

In a few months or a few years (medium term), exchange rate markets are influenced by inflation rates. Countries with relatively high inflation will tend to experience less demand for their currency than countries with lower inflation, and thus currency depreciation. Over long periods of many years, exchange rates tend to adjust toward the PPP rate, which is the exchange rate such that the prices of internationally tradable goods in different countries, when converted at the PPP exchange rate to a common currency, are similar in all economies.

15.3 Macroeconomic Effects of Exchange Rate

A central bank will be concerned about the exchange rate for several reasons. Exchange rates will affect imports and exports and thus affect aggregate demand in the economy. Fluctuations in exchange rates may cause difficulties for many firms, especially banks. The exchange rate may accompany unsustainable flows of international financial capital.

15.4 Exchange Rate Policies

In a floating exchange rate policy, a country’s exchange rate is determined in the foreign exchange market. In a soft peg exchange rate policy, a country’s exchange rate is usually determined in the foreign exchange market, but the government sometimes intervenes to strengthen or weaken the exchange rate. In a hard peg exchange rate policy, the government chooses an exchange rate. A central bank can intervene in exchange markets in two ways. It can raise or lower interest rates to make the currency stronger or weaker, or it can directly purchase or sell its currency in foreign exchange markets. All exchange rates policies face trade-offs. A hard peg exchange rate policy will reduce exchange rate fluctuations, which means that a country must focus its monetary policy on the exchange rate, not on fighting recession or controlling inflation. When a nation merges its currency with another nation, it gives up on nationally oriented monetary policy altogether.

A soft peg exchange rate policy may create additional volatility as exchange rate markets try to anticipate when and how the government will intervene. A flexible exchange rate policy allows monetary policy to focus on inflation and unemployment and allows the exchange rate to change with inflation and rates of return, but also raises a risk that exchange rates may sometimes make large and abrupt movements. The spectrum of exchange rate policies includes the following: (a) a floating exchange rate; (b) a pegged exchange rate—soft or hard—and (c) a merged currency. Monetary policy can focus on a variety of goals: (a) inflation; (b) inflation or unemployment, depending on which is the most dangerous obstacle; and (c) a long-term rule-based policy designed to keep the money supply stable and predictable.