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Foreign Exchange Market

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Economics

Where do you exchange your US dollar for Mexican Pesos when you go on holiday to Mexico? How do the currency exchange work, and where are they facilitated? Is there a market just for currencies? This article will help you learn everything you need to know about the foreign exchange market.

Foreign exchange market definition economics

International trade and openness of economies, particularly during the last century, have created a considerable trading volume of goods and services between different countries.

There are many people in the United States buying products from Japan and other parts of the world. When considering the trade between the U.S. and Japan, think that they have different domestic currencies. The currency you use to pay for goods and services in the U.S. is the U.S. dollar - $. Whereas, in Japan, you pay for goods in ¥ - Japanese yen. So how does the transaction occur when a U.S. citizen buys products in Japan? In which currency do they pay?

Well, there are two ways this can happen. A U.S. citizen either buys some Japanese Yen and then pays for Japanese goods, or it pays in U.S. dollars, and then the Japanese supplier converts the dollars into Japanese Yen. This conversion we are talking about forms a market, where one currency is exchanged for another. That market is known as the foreign exchange market.

The foreign exchange market is the market where buyers and sellers trade different pairs of currencies.

The foreign exchange market operates just like any type of other markets we’ve seen. However, instead of exchanging goods, you have currencies from different countries, and instead of prices, you have the exchange rate.

Exchange rate is the price at which the currencies are exchanged. For example, one U.S. dollar is equal to approximately 128 Japanese Yen at the time of writing. This means that one U.S. dollar can buy you 128 Japanese Yen.

The foreign exchange market is significant for countries as it allows them to conduct international trade with other countries. Moreover, it has a huge impact on economies as it determines the value of their currency, and if their currency devalues by a significant percentage, it causes turmoil in the markets. This is especially true for developing countries.

The foreign exchange market structure and graph

The foreign exchange market graph consists of the demand and supply for a given currency. There are many individuals as well as institutions involved on the demand and supply side. Additionally, the demand for foreign currency includes businesses that pay their suppliers from abroad, as well as hedge funds that trade for profits.

The demand in the foreign exchange market results from the demand for the currency to buy the country’s goods, services, and financial assets. There is an inverse relationship between the exchange rate and the quantity demanded of the currency. For example, if you were to consider the demand for the U.S. dollar, whenever the U.S. dollar would depreciate, meaning the U.S. dollar becomes cheaper, you have more quantity demanded of the U.S. dollar.

The supply in the foreign exchange market results from making payments to other countries, which causes individuals to sell their U.S. dollars to exchange it for foreign currency. There is a positive relationship between the exchange rate and quantity supplied. The higher the exchange rate, the higher the quantity supplied of the currency.

Foreign exchange market equilibrium occurs when there is such a level of exchange rate so that the quantity demanded and supplied of a currency are equalized.

Foreign Exchange Market, Graph showing equilibrium in the foreign exchange market, StudySmarterFigure 1. Foreign Exchange Market Graph-StudySmarter

Figure 1. shows the foreign exchange market graph for US dollar and Japanese Yen. You have the supply for U.S. dollars on the supply side, and on the demand side, you have the demand for the U.S. dollar.

The point where equilibrium occurs, is the point where the exchange rate forms, and it is expressed in terms of the other foreign currency for which the U.S. dollar is being exchanged, in our example - Japanese Yen. In this case, the equilibrium exchange rate forms at 128 Japanese Yen, meaning that 128 Yen is needed to buy 1 U.S. dollar. In other words, the 128 Yen represents the price of a U.S. dollar.

The equilibrium exchange rate changes only when there is a shift in either demand or supply for U.S. dollar. When the foreign exchange market is not at an equilibrium point, then we can say that a disequilibrium occurs. Disequilibrium in the foreign exchange market is associated with a shortage or surplus for a said currency. Market forces would then act to restore the balance and bring the market back to equilibrium.

To learn more about shortages and surpluses check our explanation on - Market Disequilibrium.

The structure of the foreign exchange market

Currencies like the U.S. dollar, British Pound, and the Euro, are traded in a foreign exchange market, also known as the Forex. The foreign exchange market is similar to the stock exchange market, but instead of buying and selling shares of companies, you trade currencies. The number of those participating in the foreign exchange market is huge - individual investors, institutional investors, governments, central banks, etc. The foreign exchange market is very close to a perfectly competitive market. The price is given, and none of the participants in the market is capable of influencing the price significantly.

Factors influencing foreign exchange market

Factors influencing the foreign exchange market are factors that are intrinsically linked to either the demand or the supply in the foreign exchange market. These include interest rates, economic stability, future expectations, rate of return.

To better understand how these factors influence the foreign exchange market, you need to understand shifts in the demand and supply in the foreign exchange market.

Demand shifts in foreign exchange market

Foreign Exchange Market, Graph showing a shift in demand in the foreign exchange market, StudySmarterFigure 2. A shift in demand in the foreign exchange market- StudySmarter

Figure 2. shows a rightward shift in the demand for the U.S. dollar. The new equilibrium exchange rate (located at E2) occurs at a higher level of Japanese yen per dollar. This means that more Japanese Yen are needed to buy 1 U.S. dollar. In other words, dollars can get you more Japanese yen now. This means that the exchange rate has been appreciated.

Supply shifts in foreign exchange market

Foreign Exchange Market, Graph showing a shift in supply in the foreign exchange market, StudySmarterFigure 3. A shift in supply in the foreign exchange market- StudySmarter

Figure 3. represents a shift to the right of the supply curve in the foreign exchange market. This results in a lower equilibrium exchange rate (located at E2), meaning fewer Japanese Yen are needed to buy one U.S. dollar. This causes a depreciation of the exchange rate.

Remember that in a freely floating exchange system appreciation occurs when the currency gains value, whereas depreciation occurs when the currency loses value.

Foreign Exchange Market, Graph showing currency appreciation and depreciation, StudySmarterFigure 4. Currency appreciation and depreciation in a freely floating exchange rate system - StudySmarter

Figure 4 shows the appreciation and depreciation of the currency in a freely floating exchange rate system. In a freely floating exchange rate system, the demand and supply of the currency cause a change in the value of the currency. Appreciation of currency occurs when the demand for a currency increases (shifts to the right) or when the supply of currency decreases (shifts to the left). Depreciation occurs when the demand for the currency decreases (shift to the left), or when the supply of the currency increases (shifts to the right).

Factors that can influence either the demand or the supply in the foreign exchange market

Factors that can influence either the demand or the supply in the foreign exchange market are:

Foreign Exchange Market: Interest rate

Interest rates significantly influence the foreign exchange market. Consider the case when the Fed increases the interest rate in the U.S. economy. This will encourage people in the U.S. to save more, therefore causing a decrease in the supply of the U.S. dollar on the Forex market (as they no longer want to exchange their U.S. dollar for foreign currency). When the interest rate is higher, it becomes more valuable to hold the US dollar as you get a higher return on your savings. If the interest rate went up from 5% to 10% on your savings, you would earn double on your savings. It also becomes more valuable for foreigners to make investments in the United States as the rate of return on their investment increases. This results in the appreciation of the U.S dollar.

Foreign Exchange Market: Economic stability

The economic stability of a country influences the foreign exchange market. When a country has a solid economic structure that allows for investment and growth, it will have a more valuable currency than other countries as the demand for that currency grows. However, in countries that are prone to economic instability and high inflation rates, their currency will devalue. That is because under economic instability, there will be higher inflation, and the currency will lose value every day. You could easily be paying twice the price the next month due to inflation. People living in such countries tend to keep their money in U.S. dollars or other relatively stable currencies to preserve their purchasing power. Additionally, economic instability creates a less favorable environment for foreign investors, as they are uncertain whether they can make a profit. This then reduces the demand for the currency and devalues it even further.

Foreign Exchange Market: Future expectations

Future expectations about a given currency play an influencing role in the foreign exchange market. If there are positive future expectations about the U.S. dollar, it will cause an increase in demand for the U.S. dollar. This will, in turn, appreciate the U.S. dollar.

In times of elections, there are usually huge fluctuations in exchange rates. Suppose investors expect a candidate whose economic policy is in favor of a valuation of the currency to win. In that case, they will increase the demand for the currency before the elections, resulting in an overall increase in demand for the currency, causing an appreciation of it.

Foreign Exchange Market: Rate of return

The rate of return from assets in a specific country plays an essential role in the foreign exchange market. Consider what happens in the case that the stock market in the U.S. started generating higher returns than other stock markets around the world? It will cause a shift in the demand for the U.S dollar, resulting in an appreciation of the currency.

Imagine one of the pharmaceutical companies floating in the stock market in the U.S. is close to finding a cure for cancer. Foreign investors will want to invest in the company as the cure of cancer will significantly increase the price of the company's stock, therefore providing a higher return for investors. This will cause the overall demand for the U.S. dollar to increase, causing an appreciation of the U.S dollar.

Difference between money market and foreign exchange market

The money market is where short-term loans are transferred between borrowers and lenders. On the other hand, the foreign exchange market is the market where countries' currencies are exchanged.

The main difference between the money and foreign exchange markets is the "goods" and "price units."

In the money market, you have short-term debt investments as goods, whereas in the foreign exchange market, you have a quantity of currency serving as a good.

Additionally, the "price" in the money market is expressed in terms of the interest rate, whereas the "price" in the foreign exchange market is expressed in the foreign exchange rate.

Money markets are markets that facilitate the trading of short-dated financial assets (from one day to a year).

Short-term assets like certificates of deposit, treasury bills, and repurchase agreements are traded in the money market. In contrast, currencies of different countries are traded in the foreign exchange market, such as the Australian dollar, British Pound, Euro, etc.

Functions of foreign exchange market

The foreign exchange market is important to international trade and economies around the world. The main functions of a foreign exchange market include: enabling currency exchanges, providing investment opportunities, reducing foreign exchange risk.

Foreign Exchange Market: Currency exchanges

This is perhaps the most important function of the foreign exchange market. It allows individuals of a country to exchange their currency for another country's currency. This is instrumental in conducting international trade. Businesses buy foreign currency to pay their foreign suppliers; individuals purchase foreign currency to pay for the goods and services they consume abroad.

If you were to go on a trip to Mexico, you would have to buy Pesos to pay for food and other things while traveling in Mexico. All of this is made possible by the foreign exchange market.

Foreign Exchange Market: Investment opportunities and profit

Investment opportunities and profit provided by the foreign exchange market is an important function that allows investors to grow their portfolios around the world. This involves betting against another currency and making a profit in return. The best part of it is that the gains you make from investing and trading are not taxed!

Foreign Exchange Market: Reduce foreign exchange risk

Reducing foreign exchange risk is another essential function of the foreign exchange market. Some countries are prone to economic, political, and social instability, translating into risk in terms of their currency value. To prevent investors from incurring losses, the foreign exchange market provides a forward exchange — current exchange rate agreement for a future period.

Meaning of hedging in the foreign exchange market

The meaning of hedging in the foreign exchange market refers to individuals or institutions aiming to reduce their risk exposure to foreign exchange volatility. This is a common strategy amongst investors and traders in the foreign exchange market. Usually, hedging is a short-term strategy. Traders and investors use this strategy when they expect that there will be news that will negatively affect a specific currency. One of the main instruments investor hedge in the foreign exchange market is by trading forwards and futures.

Forwards and futures are derivatives that involve an agreement on the set price of a currency at a certain date in the future. In other words, investors would agree to buy to pay a certain amount of U.S. dollars in exchange for the foreign currency on a future date, regardless of what happens to the exchange rate. So, if investors expect the U.S. dollar to appreciate in the future, they will buy forwards and futures that sell U.S. dollars at a cheaper rate. The difference between the rate they agreed and the rate that occurs in the market provides the profit for investors.

Foreign Exchange Market - Key takeaways

  • The foreign exchange market is the market where buyers and sellers trade different pairs of currencies. Exchange rate is the price at which the currencies are exchanged.
  • The demand in the foreign exchange market results from the demand for the currency to buy the country’s goods, services, and financial assets. There is an inverse relationship between the exchange rate and the quantity demanded of the currency.
  • The supply in the foreign exchange market results from making payments to other countries, which causes individuals to sell their U.S. dollars to exchange it for foreign currency. There is a positive relationship between the exchange rate and quantity supplied.
  • Foreign exchange market equilibrium occurs when there is such a level of exchange rate so that the quantity demanded and supplied of a currency are equalized.
  • The equilibrium exchange rate changes only when there is a shift in either demand or supply for U.S. dollar. When the foreign exchange market is not at an equilibrium point, then we can say that a disequilibrium occurs. Disequilibrium in the foreign exchange market is associated with a shortage or surplus for a said currency. Market forces would then act to restore the balance and bring the market back to equilibrium.

Foreign Exchange Market

The foreign exchange market is the market where buyers and sellers trade different pairs of currencies. 

Demand and supply for different currencies.

There are many individuals as well as institutions involved in the demand and supply side. Additionally, the demand for foreign currency includes businesses that pay their suppliers from abroad, as well as hedge funds that trade for profits.

Buyers and sellers come together and exchange currencies for one another.

The main functions of a foreign exchange market include: enabling currency exchanges, providing investment opportunities, reducing foreign exchange risk.

Final Foreign Exchange Market Quiz

Question

What is real exchange rate used for?

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Answer

One of the main uses of the real exchange rate is to get valuable insight into two nations' relative cost of living differences. 

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Question

What changes the real exchange rate?

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Answer

There are three main determinants of the real exchange rate: nominal interest rate, foreign prices, and domestic price level. Any change in one of these variables will also cause a change in the real exchange rate.

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What is real exchange rate?


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The real exchange rate is the exchange rate that takes into account the price level difference between the countries.

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What is the difference between nominal and real exchange rates?


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Instead of stating how much foreign money can be traded for a unit of local currency, the real exchange rate states how much products and services in the home nation can be swapped for goods and services in another country.

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What is the nominal exchange rate?

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The nominal exchange rate is the rate at which a currency may be exchanged for another currency at face value. 

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How is the nominal exchange rate calculated?

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The nominal exchange rate is calculated by determining the amount of foreign money that may be acquired for one unit of local currency. It is usually determined by supply and demand in the foreign exchange market.

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How does the nominal exchange rate impact the real exchange rate?

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Answer

An appreciation of the nominal exchange rate will cause the real exchange rate to appreciate, everything else being equal. A depreciation of the nominal exchange rate will cause the real exchange rate to depreciate, everything else being equal. 

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Question

Why an increase in the nominal exchange rate can lead to an appreciation of the real exchange rate?

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Answer

As you're counting the nominal exchange rate in terms of foreign currency per dollar, when the nominal exchange rate increases or appreciates, it means that one dollar can get you more of foreign currency. This implies that the real exchange rate value will be higher, everything else being equal.

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Question

How domestic prices affect the real exchange rate?

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Whenever there is an increase in domestic prices, there will also be an increase in the real exchange rate as it is positively correlated with domestic prices. The increase in the real interest rate means that your one U.S. good gives you more foreign goods. This makes sense as your local products are getting more expensive, each one of them should be able to provide you with more foreign goods.

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How does the foreign price level affect the real exchange rate?

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An increase in foreign prices will cause the real exchange rate to depreciate, meaning that you would need more domestic goods in exchange for the same amount of foreign goods. Think of it this way: if the real exchange rate was equal to two, meaning two foreign goods for one domestic good, and then the real exchange rate decreased to one due to an increase in price levels of the foreign country. This means that you can get only one foreign good for one of your U.S. goods. So to get 2 foreign goods as before, you would now need more of U.S. goods.

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What are the factors that influence the real exchange rate?

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Factors that influence the real exchange rate are: Terms of trade, Monetary policy, Capital inflows, Trade restrictions.

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How terms of trade influence the real exchange rate?

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Terms of trade are the relationship between the price of exported products and the price of imported items into the nation. Whenever you have export prices that increase more than the import prices, you will have positive terms of trade, and as a result, the real exchange rate will appreciate. 

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Question

How can monetary policy influence the real exchange rate?

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Answer

Monetary policy can influence the nominal interest rates directly, which would affect the real interest rate. If the Fed was to pursue an expansionary monetary policy, it would cause an increase in aggregate demand through lower interest rates. This would increase the price level in the economy. This will then cause the real exchange rate to appreciate as fewer domestic goods get you more foreign goods.

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How do capital inflows influence the real exchange rate?

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Assume that there are more capital inflows than capital outflows, meaning more investment is coming in the country than exiting. This would cause an increase in demand for the local currency, which causes the nominal exchange rate to appreciate. As the real exchange rate is positively correlated with the nominal exchange rate, the real exchange rate will also appreciate.

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How do trade restrictions influence the real exchange rate?

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Whenever the government decides to impose tariffs on imports, the real exchange rate tends to appreciate. Think about it: when tariffs are imposed, foreign goods become more expensive for domestic consumers; therefore, it will push domestic consumers to consume more of their own domestic products. This will lead to an increase in domestic products and, as a result, in a real exchange rate appreciation.

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Question

What is the foreign exchange market?

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Answer

The foreign exchange market is the market where buyers and sellers trade different pairs of currencies. 

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Question

What is the exchange rate?

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Answer

Exchange rate is the price at which the currencies are exchanged. 

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Question

Is foreign exchange market similar to a typical market in economics?

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Answer

The foreign exchange market serves just like any type of other markets we’ve seen. However, instead of exchanging goods, you have currencies from different countries, and instead of prices, you have the exchange rate.

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Where does the demand in foreign exchange market come from?

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The demand in the foreign exchange market results from the demand for the currency to buy the country’s goods, services, and financial assets. 

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Question

Where does the supply in foreign exchange market come from?

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Answer

The supply in the foreign exchange market results from making payments to other countries, which causes individuals to sell their U.S dollars to exchange it for foreign currency.  

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Question

When does the equilibrium exchange rate occur?

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Answer

When demand and supply are equal in the foreign exchange market.

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Question

When does the equilibrium exchange rate change in the foreign exchange market?

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The equilibrium exchange rate changes only when there is a shift in either demand or supply for US dollar. 

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When does disequilibrium occur in the foreign exchange market?

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Answer

When the foreign exchange market is not at an equilibrium point, then we can say that a disequilibrium occurs. 

Show question

Question

What are the factors influencing the foreign exchange market?

Show answer

Answer

Factors influencing the foreign exchange market are factors that are intrinsically linked to either the demand or the supply in the foreign exchange market; these include interest rates, economic stability, future expectations, rate of return. 

Show question

Question

What are the main functions of the foreign exchange market?

Show answer

Answer

The main functions of a foreign exchange market include: enabling currency exchanges, providing investment opportunities, reducing foreign exchange risk.

Show question

Question

What is the meaning of hedging in the foreign exchange market?

Show answer

Answer

The meaning of hedging in the foreign exchange market refers to individuals or institutions aiming to reduce their risk exposure to foreign exchange volatility. This is a common strategy amongst investors and traders in the foreign exchange market. 

Show question

Question

What is the difference between the money market and the foreign exchange market?

Show answer

Answer

The money market is where short-term loans are transferred between borrowers and lenders. 

On the other hand, the foreign exchange market is the market where countries' currencies are exchanged.

Show question

Question

Explain how interest rate influence the foreign exchange market.

Show answer

Answer

Interest rates significantly influence the foreign exchange market. Consider the case when the FED increases the interest rate in the U.S economy. This will encourage people in the U.S to save more, therefore causing a decrease in the supply of the U.S dollar ( as they no longer want to exchange their U.S dollar for foreign currency). This results in the appreciation of the U.S dollar. 

Show question

Question

Explain how economic stability influences the foreign exchange market.


Show answer

Answer

The economic stability of a country influences the foreign exchange market. When a country has a solid economic structure that allows for investment and growth, it will have a more valuable currency than other countries as the demand for that currency grows. However, in countries that are prone to economic instability and high inflation rates, their currency will devalue. 

Show question

Question

Explain how future expectations influence the foreign exchange market.

Show answer

Answer

Future expectations about a given currency play an influencing role in the foreign exchange market. If there are positive future expectations about the U.S dollar, it will cause an increase in demand for the dollar. This will, in turn, appreciate the U.S dollar.

Show question

Question

Explain how rate of return influence the foreign exchange market.


Show answer

Answer

The rate of return from assets in a specific country plays an essential role in the foreign exchange market. Consider what happens in the case that the stock market in the U.S started generating higher returns than other stock markets around the world. It will cause a shift in the demand for the U.S dollar, resulting in an appreciation of the currency. 

Show question

Question

What is appreciation of a currency?

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Answer

Appreciation occurs when the currency gains value

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What is depreciation of a currency?

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Depreciation occurs when the currency loses value. 

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Question

Define exchange rate

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Answer

The exchange rate is the rate at which one foreign currency is exchanged for another. In other words, the exchange rate refers to the price you pay for receiving a foreign currency.


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Question

If $1 is worth €0.91, how many € will $100 get you?

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If $1 is worth €0.91, $100 will get you €91. 

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What do currency exchange rates indicate?

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Currency exchange rates indicate the value of one currency in relation to another. 

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What is the formula to calculate the exchange rate?

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The total amount in foreign currency/ exchange rate = total amount in domestic currency

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Question

What are the two types of exchange rate regime?

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There are two main types of exchange rate regimes: fixed exchange rate regime and floating exchange rate regime.

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What type of exchange rate regime does the U.S have?

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The U.S has a floating exchange rate regime which means that the value of the U.S dollar is determined by supply and demand.

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Explain floating exchange rate regime.

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Floating exchange rate regimes occur when the value of the currency is determined in the foreign exchange market by the interaction of demand and supply. 

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When does a currency appreciate?

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A currency appreciates when the value of it in terms of another currency increases.

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When does a currency depreciate?

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A currency depreciates when the value of it in terms of another currency decreases.

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What is a fixed exchange rate regime?

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Fixed exchange rate regime occurs when the government or the central bank of a country keeps the exchange rate at a set level. This means that the value of the exchange rate is static and it doesn't fluctuate.

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What is a semi-fixed exchange rate regime?

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The semi-fixed exchange rate refers to the exchange rate between two currencies that is allowed to fluctuate within a set range. The range lies between the ‘price ceilings’ and ‘price floors’. Central banks usually determine semi-fixed exchange rates

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What are price ceilings?

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Price ceilings are usually set by central banks and they refer to the highest fixed rate at which currency can be exchanged for another in the semi-fixed system. 

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What are price floors?

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Answer

Price floors are usually set by central banks and they refer to the lowest fixed rate at which one currency can be exchanged for another in the semi-fixed system.

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Question

When do governments intervene to influence the exchange rate?

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Answer

Usually, the government intervenes to influence exchange rates in situations when either currency exchange rates are quickly decreasing in value or gaining too much value.

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Question

What is exchange market intervention?

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Answer

When governments intervene by either selling or purchasing a currency in the foreign exchange market, it is known as an exchange market intervention.

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Question

What are some of the methods government use to influence the exchange rate?

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Answer

Methods governments use to influence exchange rates: Buying or selling foreign exchange reserves, borrowing, increasing interest rates, reducing inflation, implementing supply-side policies, foreign exchange controls. 

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Question

What is foreign exchange controls?

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Answer

This involves having the government license the right to buy and sell a currency to certain individuals and institutions. Generally, this is done to keep the value of a currency high.

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