Chapter 17
The Foreign Exchange Market
Overview
The purpose of this chapter is to present the foreign exchange market and exchange rates, with
an emphasis on spot exchange rates. Foreign exchange is the act of trading different countries’
moneys. An exchange rate is the price of one money in terms of another. The spot exchange rate
is the price for “immediate” exchange. The forward exchange rate is the price agreed to today for
exchanges that will take place in the future. An exchange rate is confusing because there is no
natural way to quote the price. The currency that is being priced or valued by the rate is the
currency that is in the denominator.
At the center of the foreign exchange market are a group of banks that use telecommunications
and computers to conduct trades with their customers (the retail part of the market) and with each
other (the interbank part of the market). Most foreign exchange trades are conducted by
exchanging ownership of demand deposits denominated in different currencies. The box
“Foreign Exchange Trading” notes the immense size and some of the characteristics of the
foreign exchange market.
We can picture the foreign exchange market by using demand and supply curves. Exports of
goods and services and capital outflows (as well as income payments to foreigners) create a
demand for foreign currency, as payments for these items typically require that at some point in
the payment process the home currency is exchanged for the foreign currency to pay for the
items that the home residents are buying. Imports of goods and services and capital inflows (as
well as income received from foreign sources) create a supply of foreign currency, as payments
for these items typically require that at some point in the payment process the foreign currency is
exchanged for the home currency to pay for the items that the foreign residents are buying.
The text explains the downward slope of the demand curve for foreign currency through changes
in the dollar price of products that the home country might buy from the foreign country, as the
going spot exchange rate would be one or another value. (The text assumes that the supply curve
slopes upward, without much discussion at this point. The details of how values of exports and
imports respond to changes in the exchange rate are deferred until the last part of Chapter 23.)
In a floating exchange rate system without intervention by monetary authorities, the equilibrium
is at the intersection of the demand and supply curves, where the curves show all private (or
nonofficial) demand and supply. The floating exchange rate value changes as demand and supply
curves shift over time. In a fixed exchange rate system, government officials declare that the
exchange rate should be a certain level, usually within a small band around a par value. We can
still use demand and supply to analyze this system. If the equilibrium rate that the market would
set on its own (shown by the intersection of the private or nonofficial demand and supply curves)
is outside of this band, then the officials must do something to prevent the actual rate from
moving outside of the band. We focus on defense through official intervention—the officials
must buy or sell foreign currency (in exchange for domestic currency) to keep the exchange rate
value within (or at the edge of) the band. This can be pictured as filling the gap between
nonofficial supply and demand at the support-point exchange rate. (The intervention could also
be pictured as shifting the overall supply or demand curve—each overall curve would include
both nonofficial and official supply or demand—so that the new intersection occurs at the
support point.)
The chapter concludes by introducing the two different kinds of arbitrage that can occur using
the spot foreign exchange market. The simpler form is arbitrage of the same exchange rate
between two locations. This arbitrage assures that, at a particular time, the same exchange rate is
essentially the same value in different locations (at least within a small range that reflects
transactions costs). The more complicated form is triangular arbitrage—profiting from
misalignments among two exchange rates against a common currency (usually the dollar, which
is the vehicle currency in the market) and the cross-rate between the other two currencies (for
instance, pounds and Swiss francs). This type of arbitrage assures that the cross-rate essentially
equals the ratio of the other two exchange rates.
Tips
Footnote 3 explains the conventions used by traders to quote exchange rates. It also notes that we
ignore the distinction between bid and ask prices in our general discussion.
This chapter is intended to introduce key features of the foreign exchange market and present the
basic demand-supply analysis of spot exchange rates. A key goal is to get students thinking about
exchange rates as prices, about demand-supply pressures on exchange rates, and about the
opportunity for arbitrage using the foreign exchange market. At the same time students should be
assured that many of the topics, including what shifts the nonofficial supply and demand curves,
as well as government policies toward the foreign exchange market, will be taken up in more
depth as we cover the next four chapters.
We choose to picture the foreign exchange market using a standard demand and supply graph in
which the demand curve slopes downward and the supply curve slopes upward. Of course, this is
most consistent with discussions that focus on flow demand and supply (an approach that is
regaining some prominence in current research on exchange rates). Students seem to have
success grasping this approach, as it builds on their previous economics learning. The examples
in the text focus on the shape of and shifts in the demand curve, so that the instructor may choose
to present class discussion using stocks of money supply and demand, and this will appear to be
reasonably consistent with the text (except that the supply curve used in class may be vertical).
Also, as noted in the overview, we choose not to go into details at this point about the slope of
the supply curve. This detailed discussion tends to confuse some students and it diverts them
from the basic points about using demand-supply logic. Footnote 6 notes that the actual slope of
the supply curve is not clear-cut.
The box “Brussels Sprouts a New Currency” discusses the creation of the euro in 1999, the
replacement of national currencies in 2002, and the countries that have joined since 2002.
European Monetary Union is analyzed in more depth in Chapters 20 and 25.