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.
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.