Foreign Exchange Market

  

  Foreign exchange market, a market where currencies of one nation are exchanged for the currency of other nations. Exchange rates- are the rates at which currencies do exchange. Two important details about foreign exchange market should be remembered:

• These are Competitive markets– Foreign exchange markets are competitive, because here a large number of people (buyers and sellers) are dealing in standardized products (such as U.S dollars, Canadian dollars, British Pounds, European Euro).
• Linkage of Domestic Prices to Foreign Prices- Exchange rate makes a link between domestic prices and foreign ones. These rates enable consumers to translate prices of other countries to price from their own country.

Dollar-Pound Market

So how does the exchange market works? U.S firms export their goods, service and resources in U.K. They want to get their revenues in dollars, not in pounds. So U.K importers want to exchange their pounds with dollars. However, when U.S firms import some goods, services and resources from U.K, they need to offer British pounds instead of dollars. So we have a market where the “price” is in dollars and the products are in “pounds”.

The following figure shows the supply of pounds (by U.K importers) and the demand for pounds (by U.S importers).  The intersection of demand curve (D) and supply curve (S) establishes the equilibrium dollar price of pound. Here the equilibrium price of 1$ is 0.75£.

Change Rate: Appreciation and Depreciation

  What can cause the demand rate to exchange? The determinants of demand and supply of pounds is the almost the same with supply and demand for other products. In U.K several things might increase the demand for U.S dollars-also the U.K price of it.

Incomes– once the incomes are increased U.K population might buy more U.S products. So British people will need more U.S dollars (demand increases), which increases Pound price of dollar. The main point is that increasing British demand for U.S goods will increase demand for U.S dollar and raise the pound price of dollar. When the pound price of dollar increases we call it depreciation of British pound relative to U.S dollar. It takes more pounds to buy a single unit of dollar. Also we may say, the international value of British pound has declined. If inverse situation would occur, if U.S citizens demanded more British goods and services, then we would call it appreciation of British pound relative to the U.S dollar. In this case we would supply more dollars to buy a British pound. The increase in supply of dollar relative to a decrease in demand of it would decrease the equilibrium price of dollar in foreign exchange market.

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THE CIRCULAR FLOW MODEL With International Sector

                       Our initial Circular Flow Model

After we added government it looked like this:

And now we add “Other nations”  sector which interacts with our country(Let’s say Italy):

Let’s place icon “Other Countries” so that it interacts with Italian Product Markets. This sectors represents all countries (individuals, firms, governments) with which Italy has some economic relationship.

Flow (13) shows that people, firms and governments that buy Italian products, all exports from product market. This goods and services flow from Italian resource market to other nations is in contrast with (14) flow that represent an opposite monetary revenues.

Flow (15) represents Italian households, businesses, and firm’s expenditure on foreign products and services, these are also called imports (16). Purchases of foreign goods make possible those countries to buy Italian goods.

Italian imports and exports are not only goods, but also resources. Also we should take in consideration that some Italian firms activate in production abroad, which means that they are part of resource market from other countries.

There are also international flows of labor. Each year, thousands of people enter Italy. This activity increase availability of Italian labor resources, which increase Italian total output and income and decrease wage for labor force in some industries.

This figure shows that a nation which is related economically with other nations won’t face some source of instability (recession and inflation) that wouldn’t affect a “close nation”. Let’s think that Germany suffers a recession. Its incomes decline then its purchases of Italian goods will fall. Then flows (13) and (14) decline and more goods remain unsold. Italian firms would respond to this situation by limiting the supply quantity by limiting their employments, and this will reduce flow of revenues to households. Recession in Germany can create a recession in Italy.

We may also see that this “other nations” system change resource allocation and income in Italian economy. With this system Italia produce more of some goods (exports) and few of other (imports).