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The Story Behind Foreign Exchange (FOREX)

Updated on August 5, 2009

Foreign Exchange Markets

Foreign Exchange is a technical term for foreign money or foreign assets (such as bills of exchange or treasury bills) easily convertible into money.

The plural, foreign exchanges, frequently refers to the market prices at which different national currencies exchange for each other, i.e., exchange rates. The market in which foreign currency can be bought or sold is called foreign exchange market.

Before the days of Government exchange control, the foreign exchange market consisted of banks or specialized dealers in foreign exchange; under exchange control, dealings in foreign exchange are usually the monopoly of the central bank.

Under a system of different national currencies, foreign exchange or currency is required by nationals of a country for payments abroad, whether for imports of goods and services, or purchases of foreign securities, or payment of interest on foreign debt, or remittances (gifts) abroad. Foreign exchange is earned by exports abroad (including the rendering of banking or tourist services to foreigners), by interest receipts on foreign investments, and by borrowing abroad. The balance of receipts and payments of foreign exchange over a year constitutes a country's balance of (international) payments.

The economic significance of exchange rates lies in the fact that a change in the exchange value of a national currency in terms of foreign currencies alters the prices of all foreign goods and services in terms of that currency and the prices of all home-produced goods and services to foreigners. It may, therefore, bring about large changes in the flow of foreign trade. To analyze the causes and effects of changes in exchange rates is the task of the theory of foreign exchanges.

In a free foreign exchange market, exchange rates, like other prices, are determined by the interaction of supply and demand; and like other prices, changes in exchange rates, in turn, react back upon the volume of supply and demand. "Supply", in the foreign exchange market, is represented by earnings of foreign exchange (i.e., the "receipts" side of the balance of payments), "demand" by payments due abroad (i.e., the "payments" side of balance of payments). In a free market, therefore, the exchange rate will move against the home currency (i.e., the home currency will depreciate) if supply of foreign exchange falls relatively to demand, i.e., if the balance of payments deteriorates; and vice versa. Conversely, depreciation of a currency will normally improve supply relatively to demand for foreign exchange, i.e., improve the balance of payments; while appreciation will normally increase demand relatively to supply, i.e., worsen the balance of payments.

A more careful analysis can be derived from these basic principles but would be beyond the scope of this brief exposition. Two more points can be explained here:

(i) Much thought by economists has gone into discovering the factors which determine the equilibrium exchange rate, i.e., that exchange rate which will establish equilibrium (or balance) in a country's balance of payments (and which, it was once thought somewhat optimistically, will automatically establish itself in a free exchange market). A theory originally advanced by the Swedish economist Gustav Cassel after World War I, the Purchasing Power Parity Theory, argued that the equilibrium exchange rate is that rate which equalizes the purchasing power of a currency in terms of both home and foreign produced goods. It is now recognized that this theory is subject to so many qualifications as to be of little use, though it still underlies the tendency to regard relative money-wage levels in different countries as a useful guide to the appropriate exchange rates between their currencies.

(ii) The effects of a change in the exchange rate in a country like Australia, whose exports are largely primary products sold in a competitive market, are substantially different from the effects of a corresponding change in an industrial country like Great Britain. Since most Australian exports (especially wool) are sold, in any given season, for what they will fetch, the supply of exports does not depend significantly on the price obtained, and is therefore not affected by the exchange rate. In consequence, a change in the exchange value of the Australian pound does not affect the prices of Australian exports in terms of foreign exchange, nor Australia's foreign exchange earnings. It does affect the incomes of Australian export producers in terms of Australian dollars, and it raises the prices of Australian imports to Australian consumers. A depreciation of $AU, therefore, will tend to improve Australia's balance of payments by curtailing demand for foreign exchange, but not significantly by increasing supply. At the same time, it will increase the incomes of primary producers and reduce the (real) incomes of other sections of the community (whose cost-of-living rises with rising import prices), though this effect may be diminished, in the case of wage-earners, by automatic cost-of-living adjustments of the basic wage. A depreciation of the exchange rate, therefore, has an expansionary effect on the Australian economy (and therefore aided the Australian recovery from the Great Depression) and, at least in the short run, favors primary producers; conversely, an appreciation of $AU has a deflationary (or disinflationary) effect, at least in the short run, benefits the rest of the community at the expense of primary producers.

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