What is Foreign exchange market?
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| Foreign exchange market |
- It is the market in which the foreign exchange rate is determined.
It is the market where foreign currencies are traded.-
In economic the market does not have a particular place, any contact between the buyer and the seller is a market.
Types of transactions in foreign exchange market?
There are 2 types of transactions in foreign exchange market
1- Spot transaction (current transaction)
It involves immediate exchange of bank deposits when we sell and take our money now, it is a spot transaction
2- Forward transaction
It involves the exchange of bank deposits in a future date when we sell and take our money in the future it is a forward transaction
What is the foreign exchange rate?
It is the price of one country's currency in terms of another.
It is the price of domestic currency in terms of foreign currency
Ex: 1₤ =1.025541 $
There are 2 types of foreign exchange rate :
1- Spot exchange rate:
Exchange rate for spot transaction, usually we run on spot exchange rate.
2- Forward exchange rate: Exchange rate for Forward transaction.
Systems of exchange rate-
1- Fixed Exchange rate system:
The government imposes the price of its domestic currency in terms of the dollar. Under this system, there are some restrictions on the demand for foreign currency. The central bank intervenes all the time to make the Qd = Qs of foreign currency at the fixed exchange rate imposed by the government
Ex: if the demand for $ increases, its price rises above the fixed exchange rate so the central bank intervenes by selling $ to increase its supply to bring exchange rate to its fixed level
2- Flexible exchange rate system
Exchange rate determined through the market by the interaction of both demand and supply of currency.
If demand for currency increases its exchange rate rises and vice versa if the supply of currency increases its exchange rate falls.
Changes in exchange rate under the 2 systems
+ Under the fixed exchange rate system the change may be:
Devaluation:-
Means that the value of domestic currency decreases in terms of foreign currency and this action is done by the government
Revaluation:-
Means that the government will increase the value of its currency in terms of foreign currency.
+ Changes in exchange rate under the flexible systems the change may be:
Appreciation:
Means increase in the value of domestic currency in terms of foreign currency due to change in demand or supply of currency
Depreciation
Means decrease in the value of domestic currency through the market due to change in demand and supply of the currency.
Theories of determining exchange rate in the long run
3 theories explain why exchange rate changes in the long run
1- Law of one price
3- The monetary approach theory
1) Law of one price
According to law of one price, exchange rate is determined as a relative price level between the 2 countries
Rs = domestic price level / foreign price level = Pd /Pf
If there are 2 countries each one produce the same good (identical goods) and trade is opened between them, the price of this good will be the same all over the world.