December 11, 2011

Exchange Rates: Markets Regulation and International Financial System


International trade is beneficial as it increases real wages. This idea is based on the benefits of trading based on comparative advantage. But payments in international trade are based on two different currecies. A person in USA has to pay a British seller pounds to buy goods. It means a US person has to first buy pounds using his dollars. The number of dollars a US citizen has to pay for each pound is the exchange rate for pound expressed in terms of dollar.

On 24.12.2012, one pound requires 1.62 dollars. Any US person who wants pounds has to buy pounds at this exchange rate.

How are there rates (exchange rates) determined?

For foreign exchange also there are markets like there are markets for various commodities. The markets operate on the basis of demand and supply for a currency. The demand for British pounds with respect to dollars come from the people who want to buy  British goods, services and assets. Supply of pounds come from British people who want to buy US goods, services and assets. The equilibrium price for the currency is at the intersection of these two curves at any point in time.

Changes in Demand curve
The demand for British pounds from US citizens can change due to various reasons. Like, if there is better substitute produced locally in US itself, the demand for British item may go down and consequently, the demand for British pound will go down. The demand curve will shift to the left and exchange rate for Pound will go down.

The balance of supply and demand for foreign exchange determines the foreign exchange rate of a currency. It can fluctuate day by day and period by period.


When a country's foreign exchange rate has declined relative to that of another country, we say that the domestic currency has depreciated while the foreign currency has appreciated.

Government try to regulate exchange rates. When a country's official exchange rate (or policy rate) is lowered we say that the currency has undergone a devaluation.

Three major exchange rate systems are the gold standard, pure floating exchanged rates and managed floating exchange rates.


References

Paul Samuelson and William D. Nordhaus, Economics, 13th Edition, McGraw-Hill, 1989

UC Berkeley Lecture
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