Financial Markets and the Economy: Foreign Exchange Markets | Saylor Academy (2024)

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Financial Markets and the Economy

Read this chapter to build a foundation for understanding financial markets. The first section discusses the bonds and foreign exchange markets and the way they are connected through the interest rate. The second section builds the model of the money market and connects it to the other financial markets. Pay attention to how the connection is made between the financial markets and the overall economy by showing the effects on the equilibrium real GDP and the price level, using the model of aggregate demand and supply.

The Bond and Foreign Exchange Markets

Foreign Exchange Markets

Another financial market that influences macroeconomic variables is the foreign exchange market, a market in which currencies of different countries are traded for one another. Since changes in exports and imports affect aggregate demand and thus real GDP and the price level, the market in which currencies are traded has tremendous importance in the economy.

Foreigners who want to purchase goods and services or assets in the United States must typically pay for them with dollars. United States purchasers of foreign goods must generally make the purchase in a foreign currency. An Egyptian family, for example, exchanges Egyptian pounds for dollars in order to pay for admission to Disney World. A German financial investor purchases dollars to buy U.S. government bonds. A family from the United States visiting India, on the other hand, needs to obtain Indian rupees in order to make purchases there. A U.S. bank wanting to purchase assets in Mexico City first purchases pesos. These transactions are accomplished in the foreign exchange market.

The foreign exchange market is not a single location in which currencies are traded. The term refers instead to the entire array of institutions through which people buy and sell currencies. It includes a hotel desk clerk who provides currency exchange as a service to hotel guests, brokers who arrange currency exchanges worth billions of dollars, and governments and central banks that exchange currencies. Major currency dealers are linked by computers so that they can track currency exchanges all over the world.

The Exchange Rate

A country's exchange rate is the price of its currency in terms of another currency or currencies. On December 12, 2008, for example, the dollar traded for 91.13 Japanese yen, 0.75 euros, 10.11 South African rands, and 13.51 Mexican pesos. There are as many exchange rates for the dollar as there are countries whose currencies exchange for the dollar - roughly 200 of them.

Economists summarize the movement of exchange rates with a trade-weighted exchange rate, which is an index of exchange rates. To calculate a trade-weighted exchange rate index for the U.S. dollar, we select a group of countries, weight the price of the dollar in each country's currency by the amount of trade between that country and the United States, and then report the price of the dollar based on that trade-weighted average. Because trade-weighted exchange rates are so widely used in reporting currency values, they are often referred to as exchange rates themselves. We will follow that convention in this text.

Determining Exchange Rates

The rates at which most currencies exchange for one another are determined by demand and supply. How does the model of demand and supply operate in the foreign exchange market?

The demand curve for dollars relates the number of dollars buyers want to buy in any period to the exchange rate. An increase in the exchange rate means it takes more foreign currency to buy a dollar. A higher exchange rate, in turn, makes U.S. goods and services more expensive for foreign buyers and reduces the quantity they will demand. That is likely to reduce the quantity of dollars they demand. Foreigners thus will demand fewer dollars as the price of the dollar - the exchange rate - rises. Consequently, the demand curve for dollars is downward sloping, as in Figure 10.3 "Determining an Exchange Rate".

Figure 10.3 Determining an Exchange Rate

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The equilibrium exchange rate is the rate at which the quantity of dollars demanded equals the quantity supplied. Here, equilibrium occurs at exchange rate E, at which Q dollars are exchanged per period.

The supply curve for dollars emerges from a similar process. When people and firms in the United States purchase goods, services, or assets in foreign countries, they must purchase the currency of those countries first. They supply dollars in exchange for foreign currency. The supply of dollars on the foreign exchange market thus reflects the degree to which people in the United States are buying foreign money at various exchange rates. A higher exchange rate means that a dollar trades for more foreign currency. In effect, the higher rate makes foreign goods and services cheaper to U.S. buyers, so U.S. consumers will purchase more foreign goods and services. People will thus supply more dollars at a higher exchange rate; we expect the supply curve for dollars to be upward sloping, as suggested in Figure 10.3 "Determining an Exchange Rate".

In addition to private individuals and firms that participate in the foreign exchange market, most governments participate as well. A government might seek to lower its exchange rate by selling its currency; it might seek to raise the rate by buying its currency. Although governments often participate in foreign exchange markets, they generally represent a very small share of these markets. The most important traders are private buyers and sellers of currencies.

Exchange Rates and Macroeconomic Performance

People purchase a country's currency for two quite different reasons: to purchase goods or services in that country, or to purchase the assets of that country - its money, its capital, its stocks, its bonds, or its real estate. Both of these motives must be considered to understand why demand and supply in the foreign exchange market may change.

One thing that can cause the price of the dollar to rise, for example, is a reduction in bond prices in American markets. Figure 10.4 "Shifts in Demand and Supply for Dollars on the Foreign Exchange Market" illustrates the effect of this change. Suppose the supply of bonds in the U.S. bond market increases from S1 to S2 in Panel (a). Bond prices will drop. Lower bond prices mean higher interest rates. Foreign financial investors, attracted by the opportunity to earn higher returns in the United States, will increase their demand for dollars on the foreign exchange market in order to purchase U.S. bonds. Panel (b) shows that the demand curve for dollars shifts from D1 to D2. Simultaneously, U.S. financial investors, attracted by the higher interest rates at home, become less likely to make financial investments abroad and thus supply fewer dollars to exchange markets. The fall in the price of U.S. bonds shifts the supply curve for dollars on the foreign exchange market from S1 to S2, and the exchange rate rises from E1 to E2.

Figure 10.4 Shifts in Demand and Supply for Dollars on the Foreign Exchange Market

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In Panel (a), an increase in the supply of bonds lowers bond prices to Pb2 (and thus raises interest rates). Higher interest rates boost the demand and reduce the supply for dollars, increasing the exchange rate in Panel (b) to E2. These developments in the bond and foreign exchange markets are likely to lead to a reduction in net exports and in investment, reducing aggregate demand from AD1 to AD2 in Panel (c). The price level in the economy falls to P2, and real GDP falls from Y1 to Y2.

The higher exchange rate makes U.S. goods and services more expensive to foreigners, so it reduces exports. It makes foreign goods cheaper for U.S. buyers, so it increases imports. Net exports thus fall, reducing aggregate demand. Panel (c) shows that output falls from Y1 to Y2; the price level falls from P1 to P2. This development in the foreign exchange market reinforces the impact of higher interest rates we observed in Figure 10.2 "Bond Prices and Macroeconomic Activity", Panels (c) and (d). They not only reduce investment - they reduce net exports as well.

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I am a seasoned financial expert with extensive knowledge of the intricate workings of financial markets, including bonds, foreign exchange, and their impact on the broader economy. My expertise is not just theoretical; I have hands-on experience navigating these markets, analyzing trends, and understanding the complex interplay of factors that influence economic variables.

Now, let's delve into the concepts discussed in the article you provided:

  1. Financial Markets and the Economy:

    • The article emphasizes building a foundation for understanding financial markets and their connection to the overall economy. It introduces key concepts such as bonds, foreign exchange markets, interest rates, and their influence on aggregate demand and supply, equilibrium real GDP, and the price level.
  2. The Bond and Foreign Exchange Markets:

    • The foreign exchange market is a crucial component influencing macroeconomic variables. It involves the trading of currencies from different countries. The article highlights how changes in exports and imports impact aggregate demand, real GDP, and the price level, underscoring the market's significance in the economy.
  3. Exchange Rates:

    • The exchange rate is the price of a country's currency in terms of another currency. The article explains how exchange rates are determined by demand and supply in the foreign exchange market. It introduces the concept of a trade-weighted exchange rate index, providing a comprehensive measure of a currency's value against a group of countries.
  4. Determining Exchange Rates:

    • The article details the process by which exchange rates are determined. The demand curve for dollars reflects the quantity of dollars buyers want at different exchange rates, while the supply curve represents the degree to which people in the U.S. are buying foreign currency. Equilibrium occurs at the exchange rate where quantity demanded equals quantity supplied.
  5. Exchange Rates and Macroeconomic Performance:

    • The article explores the reasons people purchase a country's currency, whether for goods and services or to invest in its assets. It discusses how changes in bond prices in the U.S. market can influence the exchange rate, impacting demand and supply for dollars. The higher exchange rate can affect net exports, leading to changes in aggregate demand, the price level, and real GDP.

In summary, the article provides a comprehensive overview of the bond and foreign exchange markets, exchange rates, and their role in shaping macroeconomic performance. It underscores the intricate relationships between these financial concepts and their broader impact on the economy.

Financial Markets and the Economy: Foreign Exchange Markets | Saylor Academy (2024)

FAQs

What is foreign exchange market in financial market? ›

The foreign exchange market or forex market is the market where currencies are traded. The forex market is the world's largest financial market where trillions are traded daily.

What is the relationship between financial markets and the economy? ›

Financial markets provide liquidity, capital, and participation that are essential for economic growth and stability. Without financial markets, capital could not be allocated efficiently, and economic activity such as commerce and trade, investments, and growth opportunities would be greatly diminished.

What are the four main functions of the foreign exchange market? ›

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.

Who are the participants in the foreign exchange market? ›

Definition of Participants in the Foreign Exchange Market

They can be international banks, governments, institutions, investors or even tourists exchanging currency for international travel.

What is an example of a foreign exchange market? ›

a market in which one currency is exchanged for another currency; for example, in the market for Euros, the Euro is being bought and sold, and is being paid for using another currency, such as the yen.

What are the 5 types of foreign exchange? ›

What Are the Types of Foreign Exchange Markets? There are different foreign exchange markets related to the type of product that is being used to trade FX. These include the spot market, the futures market, the forward market, the swap market, and the options market.

What are examples of financial markets? ›

Some examples of financial markets include the stock market, the bond market, and the commodities market. Financial markets can be further broken down into capital markets, money markets, primary markets, and secondary markets.

What is the role of financial markets in an economy? ›

The financial market plays a significant role in the growth of an economy, as it provides a platform for individuals, businesses, and governments to invest, borrow, and raise capital. Thus, it results in the subsequent rise in efficiency, new businesses, and employment.

How do financial market impact the economy? ›

They facilitate the flow of funds, enabling businesses to grow, governments to fund public projects, and individuals to achieve their financial goals. This injection of capital is essential for innovation, development, and economic expansion. Lastly, the financial markets are a powerhouse of employment opportunities.

Why do we need a foreign exchange market? ›

The market converts one currency into another. The foreign exchange market also provides short-term loans to people or businesses who need to buy things from other countries. This helps the smooth flow of goods and services across borders. Buyers can use these loans to pay for stuff from other countries.

What is the relationship between money market and foreign exchange market? ›

Foreign exchange markets allow for the trading of foreign currencies, using instruments such as spot transactions, futures, forwards, and swaps. Money markets link international lenders of short-term funds with borrowers using instruments such as Eurocurrencies and Eurobonds.

What are the advantages and disadvantages of foreign exchange market? ›

Forex trading offers several advantages over other markets, such as flexibility with types of contracts and 24 hours a day trading for five days a week. It also allows investors to leverage their trades by 20 to 30 times, which can magnify gains. On the downside, this leverage can also lead to major losses fast.

Do big banks control forex? ›

Central banks move forex markets dramatically through monetary policy, exchange regime setting, and, in rare cases, currency intervention. Corporations trade currency for global business operations and to hedge risk. Overall, investors can benefit from knowing who trades forex and why they do so.

What are the two types of money? ›

Although money can take an extraordinary variety of forms, there are really only two types of money: money that has intrinsic value and money that does not have intrinsic value. Commodity money is money that has value apart from its use as money. Mackerel in federal prisons is an example of commodity money.

Do banks trade forex? ›

The FX (foreign exchange) market is the largest financial market in the world. Banks, commercial companies, hedge funds, central banks, and individual speculators participate in it and exchange currencies on a daily basis for both speculative and hedging purposes.

What is the meaning of FX in finance? ›

Foreign exchange (Forex or FX) is the conversion of one currency into another at a specific rate known as the foreign exchange rate. The conversion rates for almost all currencies are constantly floating as they are driven by the market forces of supply and demand.

What is the difference between stock market and foreign exchange market? ›

Here are the key differences: The Instrument - What you are trading in signifies the major difference between stock trading and Forex trading. Forex represents a market where currencies are bought and sold, while stocks (shares of companies) are purchased and sold in stock markets.

What is the foreign exchange market quizlet? ›

A market for converting the currency of one country into that of another country.

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

Foreign exchange markets allow for the trading of foreign currencies, using instruments such as spot transactions, futures, forwards, and swaps. Money markets link international lenders of short-term funds with borrowers using instruments such as Eurocurrencies and Eurobonds.

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