1. THE FOREIGN EXCHANGE
MARKET
MODULE 42

2. WHAT IS THE FOREIGN EXCHANGE
MARKET?
The foreign exchange market (currency,
Forex, or FX) trades currencies. It lets
banks and other institutions easily buy and
sell currencies.
The purpose of the foreign exchange
market is to help international trade and
investment. A foreign exchange market
helps businesses convert one currency to
another. For example, it permits a U.S.
business to import European goods and
pay Euros, even though the business's
income is in U.S. dollars.

3. THE FOREIGN EXCHANGE MARKET IS
UNIQUE BECAUSE OF:
Trading volumes
The extreme liquidity of the market
Its geographical dispersion
Its long trading hours: 24 hours a day
except on weekends
The variety of factors that affect exchange
rates
The low margins of profit compared with
other markets of fixed income (but profits
can be high due to very large trading
volumes)

4. THE FOREIGN EXCHANGE MARKET IS
UNIQUE BECAUSE OF:
Trading volumes
The extreme liquidity of the market
Its geographical dispersion
Its long trading hours: 24 hours a day
except on weekends
The variety of factors that affect exchange
rates
The low margins of profit compared with
other markets of fixed income (but profits
can be high due to very large trading
volumes)

5. THE ROLE OF THE EXCHANGE
RATE
The exchange rate, which is determined
in the foreign exchange market ensures
that the balance of payments really does
balance.
Exchange rates are the equilibrium
prices for national currencies.
An exchange rate shows how much of a
nation’s currency is needed to purchase
a unit of another’s currency.

6. UNDERSTANDING EXCHANGE
RATES
International transactions require a
market in which currencies can be
exchanged for each other.
This market is the foreign exchange
market, and it establishes the exchange
rates.
The exchange rates are the prices at
which currencies trade.

7. UNDERSTANDING EXCHANGE
RATES
Exchange rates can be written in two
ways:
(exchanges as of May 9, 2012)
U.S. dollars Yen Euros
One U.S. dollar
exchanged for
1 79.6299 0.772900
One yen
exchanged for
0.0125583 1 0.00970430
One euro
exchanged for
1.29389 103.047 1

8. UNDERSTANDING EXCHANGE RATES
When a currency becomes more valuable
in terms of other currencies, economists
say the currency appreciates.
When a currency becomes less valuable in
terms of other currencies, it depreciates.
Movements in exchange rates, ceteris
paribus, affect the relative prices of goods,
services, and assets in different countries.

9. THE EQUILIBRIUM EXCHANGE RATE
The equilibrium exchange rate is the
exchange rate at which the quantity of
currency demanded in the foreign
exchange market is equal to the quantity
of currency supplied.
Movements in the exchange rate ensure
that changes in the financial account and
the current account offset each other.

10. DOLLAR-YEN MARKET
In the dollar-yen market, the dollar price
of a yen would be on the vertical axis
and the quantity of yen would be on the
horizontal axis. The intersection of the
up-sloping supply of yen curve and
down-sloping demand for yen would
determine the dollar price of a yen.

11. DOLLAR-YEN MARKET
If US demand for Japanese goods
increased, more yen would be needed to
pay for the goods, and so the demand for
yen would increase. This change
increases the dollar price of yen, which
means there has been a depreciation of
the US dollar relative to the yen.

12. DOLLAR-YEN MARKET
Conversely, if Japanese demand for US
goods increased, more dollars would be
needed to pay for the goods, and the
supply of yen would increase. This
change will decrease the dollar price of
yen, which means there has been an
appreciation of the US dollar relative to
the yen.

13. CURRENCY APPRECIATION AND
DEPRECIATION
The dollar price of foreign
currency rises 

Foreign currency price of
dollar falls 
International value of the dollar
falls
(dollar depreciates)

International value of foreign
currency rises
(foreign currency appreciates)

14. INFLATION AND REAL EXCHANGE
RATES
To take into account the effects of
differences in inflation rates, economists
calculate the real exchange rates,
which are the exchange rates adjusted
for international differences in aggregate
price levels.

15. INFLATION AND REAL EXCHANGE
RATES: AN EXAMPLE
If PUS and PMEX are the indexes of the
aggregate price level in the U.S. and
Mexico.
The real exchange rate between the
Mexican peso and the U.S. dollar is defined
as:
Real exchange rate= Mexican pesos per U.S. dollar x
𝑃𝑢𝑠
𝑃 𝑚𝑒𝑥
The exchange rate unadjusted for
aggregate price levels is sometimes called
the nominal exchange rate.

16. INFLATION AND REAL EXCHANGE
RATES: AN EXAMPLE
Suppose the Mexican peso depreciates
against the U.S. dollar, with the
exchange rate going from 10 pesos to 15
pesos per U.S. dollar, which is a 50%
change.
At the same time the prices in Mexico
increase by 50%, so that the price index
rises from 100 to 150.

17. INFLATION AND REAL EXCHANGE
RATES: AN EXAMPLE
Assuming there is no change in U.S. prices, so
the U.S. price index remains at 100.
1. The initial real exchange rate is:
Pesos per dollar x
𝑃𝑢𝑠
𝑃𝑚𝑒𝑥
= 10 x
100
100
= 10
2. After the peso depreciates and the Mexican
price level increases, the real exchange rate
is:
Pesos per dollar x
𝑃𝑢𝑠
𝑃𝑚𝑒𝑥
= 15 x
100
150
= 10

18. INFLATION AND REAL EXCHANGE
RATES: AN EXAMPLE
In this example, the peso has depreciated
significantly in terms of the U.S. dollar, but the
real exchange rate between the peso and the
U.S. dollar has not changed at all.
And because the real peso-U.S. dollar
exchange rate has not changed, the nominal
depreciation of the peso against the U.S. dollar
will have no effect on the quantity of goods
traded between the countries.

19. INFLATION AND REAL EXCHANGE
RATES: AN EXAMPLE
The current account responds only to a
change in the real exchange rate, not the
nominal exchange rate.
A country’s products become cheaper to
foreigners only when that country’s
currency depreciates in real terms.

20. PURCHASING POWER PARITY
The purchasing power parity between
two countries’ is the nominal exchange
rate at which a given basket of goods
and services would cost the same
amount in each country.

21. PURCHASING POWER PARITY
For example, if the same basket of
goods and services costs 800 pesos in
Mexico and $100 in the U.S. the PPP
would be:
800 pesos = $100
8 pesos per $1

22. PURCHASING POWER PARITY
Nominal exchange rates almost always
differ from purchasing power parities.
Some of the differences are systematic:
in general, aggregate price levels are
lower in poor countries than in rich
countries because services tend to be
cheaper in poor countries.

23. PURCHASING POWER PARITY
But even among countries with roughly
the same amount of economic
development, nominal exchange rates
vary quite a lot from the purchasing
power parity.
Over the long run, however, purchasing
power parities are quite good at
predicting actual changes in nominal
exchange rates.

24. PURCHASING POWER PARITY
In particular, nominal exchange rates
between countries at similar levels of
economic development tend to fluctuate
around levels that lead to similar costs
for a given market basket.