Foreign Exchange Markets and Exchange Rates When Americans buy goods or services produced in foreign countries, they normally must first buy the currencies used in those foreign countries. For example, when an importing firm in New York buys European beer, payment to the European brewery must be made in euros, not dollars. Similarly, if a European resident wants to vacation in Florida or buy goods from the U. S. , he or she must buy dollars. A market for currencies, known as the foreign exchange market, thus arises alongside the world market for goods and services.

However, it is not only trade in goods and services that generates trade in foreign exchange. World capital markets also result in foreign exchange transactions. For example, if an American resident wishes to buy stocks, bonds, real estate, or other assets in Europe, he or she must first buy euros. The price at which a currency exchanges for another currency in the foreign exchange market is referred to as an exchange rate. An exchange rate is a relative price of one currency in terms of another.

For example, in May 2002, the price of a European euro in U. S. currency was about \$0. 92.

But if the exchange rate of the euro was \$0. 92, this also meant that the exchange rate of the dollar in terms of euros was about 1. 09 euros (1/0. 92 = 1. 09). The dollar price of the euro is just the reciprocal of the euro price of the dollar, and vice versa.

Supply and Demand for Currencies In order to understand the following model of exchange rates, you first need to understand the basic model of supply and demand. For more information, refer to the notes for Micro Topic 3. Assume that the world consists of two countries, the U. S. and Europe. Individuals in these two countries trade with one another in goods and services, as well as in financial assets.

Consequently, a market for foreign exchange arises, which can be characterized in two ways -- as a demand and supply of dollars, or as a demand and supply of euros. Because the price of dollars in terms of euros is just the inverse of the price of euros in terms of dollars, these two ways of characterizing the foreign exchange market are really equivalent. It doesn't matter whether we draw supply and demand curves for dollars or supply and demand curves for euros, as long as we remember how to interpret the price in each case, and remember that if the dollar price of euros rises then, by definition, the euro price of dollars falls, and vice versa. Price of euros in dollars e Price of dollars in euros 1/e Quantity of euros Quantity of dollars S D S D e 1 e 0 = \$0. 92 e 2 1/e = 1. 09 euros 0 1/e 2 1/e 1 A B C D C' D' A' B' Figure 8.

1 To illustrate, consider Figure 8. 1. In panel (a) we illustrate the market for euros. On the vertical axis we measure the exchange rate, e, which in this case is defined as the price of euros in terms of dollars (dollars per euro, or \$/^I).

On the horizontal axis is the quantity of euros traded in the foreign exchange market. The demand for euros represents the behavior of Americans and others who wish to buy European goods and assets. The demand is downward sloping. Why? As the euro weakens against the dollar, i.

e. , as e falls, each dollar buys more euros, and therefore the dollar prices of European goods and assets fall. This induces Americans to buy more European goods and assets, and consequently increases the quantity of euros demanded by Americans. The supply curve of euros in Figure 8. 1 (a) represents the behavior of Europeans and others who wish to buy American goods and assets. The supply is upward sloping.

Why? As the euro strengthens against the dollar, i. e. , as e increases, each euro buys more dollars, so the euro prices of American goods and assets fall. This induces Europeans to buy more American goods and assets, which means they are supplying a greater quantity of euros to the foreign exchange market. The equilibrium exchange rate in Figure 8. 1 (a) is e 0, which is \$0.

92. This is the market-clearing exchange rate, where the quantity of euros demanded in the foreign exchange market is exactly equal to the quantity of euros supplied. If the actual exchange rate exceeded e 0, for example if the exchange rate were e 1 instead, then there would be an excess supply of euros equal to AB. At a price of e 1, more euros are offered for sale than buyers wish to purchase, and competition among sellers will drive the exchange rate down until quantity supplied once again equals quantity demanded at e 0. If the actual exchange rate were to drop below e 0, say to e 2, then there would be an excess demand for euros equal to CD. At a price of e 2, buyers wish to purchase more euros than sellers are offering for sale, and competition among buyers will drive the exchange rate back up to e 0.

Note that, since the supply of euros arises from purchases of American goods by European residents, and since the demand for euros derives from Americans' purchases of European goods, it follows that if there is an excess supply of euros in Figure 1 (a), this means that at the prevailing exchange rate of e 1, Europeans are buying more goods from Americans than Americans are buying from Europeans. Consequently, an excess supply of euros means that Europe has a trade deficit (European imports exceed European exports) while the U. S. has a trade surplus (U.

S. exports exceed U. S. imports). Conversely, if there is an excess demand for euros in Figure 8. 1 (a), this means that at the prevailing exchange rate of e 2, Americans are buying more goods from Europeans than Europeans are buying from Americans.

Therefore, at e 2 the U. S. has a trade deficit and Europe has a trade surplus. However, excess demands and excess supplies of foreign exchange are eliminated automatically, in a regime of flexible exchange rates, by adjustments of the exchange rate toward market-clearing equilibrium. It follows that under flexible exchange rates, trade deficits and surpluses are likewise eliminated through changes in market exchange rates.

For example, if there is an excess supply of euros, as at e 1 in Figure 8. 1 (a), the resulting fall in the euro exchange rate to e 0 will raise the euro prices of American goods and lower the dollar prices of European goods, therefore reducing the quantity of American goods demanded by Europeans and increasing the quantity of European goods demanded by Americans, and hence eliminating both Europe's trade deficit and the U. S.'s trade surplus.