The Foreign Exchange Market
The foreign exchange market provides the physical and institutional means through which the currency of one country is exchanged for that of another country. A foreign exchange transaction is an agreement between a buyer and a seller that a given amount of one currency is to be delivered at a specified price (rate) for some other currency.
The Exchange Rate
An exchange rate is the rate at which one currency can be exchanged for another currency. In other words, it is the value of a country's currency in terms of another country’s currency. In the same way that there is a price for any other commodity, there is also a price for the currency of other countries which is the exchange rate.
Exchange Rate System
There are three broad categories of exchange rate systems:
Free or Flexible-Floating Systems
In a free-floating exchange rate system, governments and Central Banks do not participate in the market for foreign exchange since it is left to the market. The demand for and supply of the currency on the foreign exchange market determine the price (exchange rate) for the currency.
Managed Float Systems
Under a managed float, exchange rates are still free to float based on market demand and supply, however, governments may influence their values by limiting the extent of the float so as to prevent sudden large swings in the value of a nation’s currency.
Fixed Exchange Rates
A fixed exchange rate system is an exchange rate system in which governments try to maintain the currency value that is constant against a specific currency. This is also referred to as pegging the exchange rate. In a fixed exchange-rate system, a country's government decides the worth of its currency against those of other countries. To ensure that a currency will maintain its pegged value, the country's central bank maintains reserves of foreign currencies and gold. They can sell these reserves in order to intervene in the foreign exchange market to meet excess demand or take up excess supply of the country's currency.
Determination of the Exchange Rate
In the floating exchange rate regime, the exchange rate is determined by the forces of demand and supply.
Equilibrium Exchange Rates
The equilibrium exchange rate occurs where demand for the home currency equals supply. Those in favour of a floating exchange rate regime argue that allowing exchange rates to float will enable trade to balance more quickly. The equilibrium exchange rate will be P0 which is where the demand curve D0 equals the supply curve S0 and equilibrium quantity is Q0 as can be seen in the following graph.
Increase in Demand for the Local Currency
A change in either demand for or supply of the currency will lead to a change in the equilibrium price (exchange rate). For example, if there is an increase in the demand for the local Dollar by foreigners, the demand curve for the local Dollar will therefore shift to the right from D0 to D1. This results in an increase in quantity supplied of the local Dollar from Q0 to Q1 and the price of the local Dollar will increase from $0.15US= $1LD to $0.40US=$1LD as seen in the following graph. This increase in the price of the local Dollar translates into a rise in the value or an appreciation of the local Dollar. This is the same as saying that US goods will now cost less for the local citizens.
Depreciation and Appreciation
A depreciation refers to a fall in the value of a country’s currency on the foreign exchange market. This will result in imports becoming more expensive and exports cheaper. On the other hand, an appreciation refers to a rise in the value of the country’s currency. If there is a currency appreciation, the country’s residents will find imported goods to be cheaper relative to goods produced domestically, and the volume of imports will increase.
Devaluation and Revaluation
Devaluation is the deliberate downward adjustment in the official exchange rate which reduces the currency's value. A devaluation works the same as that of a depreciation where the former is for the case of a fixed exchange rate system while the latter is for the case of a flexible exchange rate system.
In the case of a devaluation, imports become more expensive and so there will be a shift towards local products. In contrast, a revaluation is an upward change in the currency's value which increases the value of the country’s currency. With a revaluation, the foreign price of exports will increase and imports will become cheaper relative to exports and so imports will tend to rise.
Nominal vs. Real Exchange Rate
The nominal exchange rate defines the value of a given currency that can be traded for a single unit of another. On the other hand, the real exchange rate outlines the amount of goods or services in a given country that can be exchanged for a single unit of that good or service in a different country.
Effective exchange rate
The effective exchange rate measures a currency against a basket of other currencies. This is usually trade-weighted. When looking at the effective Canadian Dollar exchange rate we will compare the value of Canadian Dollar against the currencies of Canada’s main trading partners – the Euro, the US Dollar and the Yen and give a weighting depending on how much Canada trades with that country, for example, the US, 70 percent.
Marshall Learner Condition
The Marshall–Lerner condition (after Alfred Marshall and Abba P. Lerner) refers to the condition where an exchange rate devaluation or depreciation will only cause a balance of trade improvement if the absolute sum of the long-term export and import demand elasticities is greater than unity. If the domestic currency devalues, imports become more expensive and exports become cheaper due the change in relative prices. Initially, we will expect to see a deterioration of the trade balance which can be attributed to time delays in adjustments resulting from the devaluation. However, in the long-term when the prices become flexible, there will be a positive quantity effect on the balance of trade because domestic consumers will buy fewer imports and foreign consumers will buy more of our exports; but offsetting this is a negative cost effect on the balance of trade, since the relative cost of imports will be higher. Whether the net effect on the trade balance is positive or negative depends on whether or not the quantity effect outweighs the cost effect; if the quantity effect is greater, then it is said that the Marshall–Lerner condition is met.
J-Curves in economics
The J-curve effect is an aspect of economics that deals with the impact on a country’s balance of payments based on changes in its currency. For example, when a country’s currency has depreciated or devalued, its initial trade balance will worsen. The now higher exchange rate will cause imports to become more expensive and exports to be less valuable. This will lead to a bigger deficit or smaller surplus. Due to the relatively low-priced exports, the affected country's exports of the goods will begin to increase as external demand for the country’s lower-priced exports will increase. The end result will be that the trade balance will eventually improve to better levels compared to the initial impact of the devaluation as can be in the following graph. Initially, the trade balance decreases and then starts to rise.