Foreign Exchange Markets Summary

Domestic residents in an open economy often have dealings with international transactions. American car dealers, for example, buy Japanese Toyotas and Datsuns, while German computer companies sell electronic notebooks to Mexican businessmen. Similarly, Australian mutual funds invest in the shares of companies all over the world, while the treasurer of a Canadian transnational corporation parks idle cash in 90-day Bank of England notes. Most of these transactions require one or more participants to acquire a foreign currency. If an American buys a Toyota and pays the Japanese Toyota dealer in dollars, for example, the latter will have to exchange the dollars for yens in order to have the local currency with which to pay his workers and local suppliers (Douglass, 2002).

The foreign exchange market is the market in which national currencies are traded. As in any market, a price must exist at which trade can occur (Douglass, 2002). An exchange rate is the price of a unit of domestic currency in terms of a foreign currency. Therefore, if the exchange rate of the dollar in terms of the Japanese yen increases, we say the dollar has depreciated and the yen has appreciated. Similarly, a decrease in the dollar/yen exchange rate would imply an appreciation of the dollar and a depreciation of the yen.

The world has a few major foreign currency exchange markets. These are the freely floating exchange rates, fixed rate currency exchange markets, and managed or float, also known as dirty. Each one has there advantages and disadvantages and we will cover these issues now.

The freely floating exchange rates tend to respond quickly to shifts in the currency market. Therefore, it's easier to watch and predict. Because of this quick response time, excess demand or excess supplies are quickly eliminated by rate adjustments in the currency market. This makes for a much more controllable market. However, freely floating exchange rates are not without there disadvantages. Unstable currency exchange rates may be harmful to some import or export activity. Businesses that rely on exports from that country will be hindered by unexpected appreciations of currency in that country and also importers will be hurt by unexpected inflation in their domestic currency. Especially in LDCs and NICs (Countries in early - LDC - or intermediate - NIC stages of economic development) foreign trade is such a significant portion of GDP that currency market swings drastically effect overall economic stability, especially employment and industries in import/export reliant sectors. The former chairperson of the Federal Reserve Arthur F. Burns reported four drawbacks to the free float. The first was that people will demand industry protection when their company is harmed by an unexpected shock to the currency value. The next was that if other nations suspect the U.S. government is manipulating our floating exchange rate, they will retaliate (i.e. lower their own currency valuation to stimulate more exports to the U.S.) Then, uncertainty in currency markets will stifle business activity. Finally, the Float limits the effectiveness of any financial or monetary policy moves.

Of course with any criticism there must be a response. Freely floating exchanges have for the most part avoided radical swings due to arbitrage, or the investment of buying an asset (like 1000 units of a given currency) and selling it for more in another market. If Yen plummets in value against the British Pound, investors will buy significant quantities and sell these Yen for Euros, Dollars, Pesos, and for various other currencies as long as they can make a profit in doing this. The result is stability in the Yen. (This assumes all mentioned currencies use free float system). Also some uncertainty is an acceptable cost for the efficiency of a currency value that adjusts quickly to eliminate disequilibria.

Another currency exchange market is the fixed rate. This is when governments come to an agreement between each other about the exchange rates. This means the value of their currency is targeted, meaning supply must keep pace with a positive shock to demand for that country's currency. Oh the other hand, demand must keep pace with a positive shock to supply of currency, which would happen if citizens buy more imports. This requires assets to be held as International Reserves, the stockpile of currencies for the countries that a fixed-exchange deal has been struck with. The other option is for these countries to keep these International Reserves in accounts with the IMF or another globally accepted financial agency.

Finally is the managed or "dirty" float exchange. This is a float within a range of values to which the currency is "pegged" or targeted. The Federal Reserve can influence the currency strength in the interest of remaining in the targeted range. In some LDC's, the foreign currency is rationed