What is the foreign exchange market? How is the value of a currency determined?
If you have ever traveled outside of the country, you have likely dealt with the process of exchanging your national currency for that of the country you are traveling to. You have also probably noticed that the price tag on an item from your home country might look very different from that of the country you are visiting. For example, a new pair of sneakers that costs 50 dollars in the US might cost 500 Swedish Krona in Stockholm. So what determines the values of these currencies? The answer lies in the foreign exchange market.
What is the foreign exchange market?
Often referred to as simply FOREX, the Foreign Exchange market is a decentralized financial marketplace where traders can buy and sell different currencies. Unlike some marketplaces and stock exchanges, the decentralized nature of this network is significant, as it is not tied down to a physical location. The FOREX market is also interesting in that it can be split into two different levels. The first level is that of the interbank market. This top-level of the FOREX market is primarily composed of private banks that conduct significant transactions, often experiencing trillions of dollars in transactions every day. On the second level of the FOREX market is the Over-The-Counter (OTC) market, where individuals and companies have the opportunity to participate. Together, the supply and demand forces of the foreign exchange market determine a currency’s floating exchange rate and help indicate the value of said currency.
How does the value of a currency change?
To understand how the value of a currency changes, it is worth knowing that when the value of a currency increases or decreases, these changes are always relative to that of another currency. This means that if the US Dollar increases in value (or appreciates) relative to the Euro, the Euro has lost value (and depreciated) with relation to the USD. Additionally, the basic laws of supply and demand can be applied to understand exchange rates. For instance, if something causes the supply of Yen on the foreign exchange market to increase (or the demand for it decreases) then the Yen will, relatively, drop in value. An increase in demand or decrease in supply would cause the opposite to occur.
What factors affect a currency’s supply and demand?
There are a number of factors that affect the supply and demand of a currency on the foreign exchange market. A change in any one of these factors will cause a reciprocated change in that currency’s value. While these factors are numerous and complex, on a basic level, they often include price level, interest rates, tastes, income, and political stability. If, for example, Country A is experiencing heavy inflation and has a higher price level than Country B (which has a lower inflation rate), there will be an observed increase in demand for currency from Country B. Or, in contrast, if Country A has a higher interest rate than Country B, foreign investors will move their capital to Country A, and its currency will appreciate. Changes in income also affect the quantity of goods and services that a country imports, and as good and services must be paid for in the currency of the country where they are being sold, supply and demand will be affected. Finally, an increase in political turmoil or instability is associated with an increase in risk, and will cause a currency to depreciate.
What is the difference between floating and fixed exchange rates?
The values of many currencies are controlled by floating exchange rates. These exchange rates are dictated entirely by the supply and demand forces of the market and are said to be self-correcting. However, many currencies are not free-floating, and instead deemed to be fixed, or pegged. These fixed exchange rates differ from floating exchange rates in that the government or central bank of a country is responsible for setting and maintain that currency’s value. Although central banks don’t normally trade currencies, they do have the ability to control foreign exchange reserves and interest rates in a way that can significantly affect a currency’s value.
Historically, the values of many countries’ currencies were determined by the gold standard. Following the Great Depression, however, this system began to disappear. Then, in 1944, the Bretton Woods Agreement fixed the values of international currencies to the US dollar, which was still being determined by the price of gold. In 1973, Nixon ended this system and the Foreign Exchange market developed into what it is today.
While many countries transitioned to floating exchange rates, fixed exchange rates (as controlled by a Central Bank) are not uncommon. Sometimes, for example, countries, such as Saudi Arabia, with economies heavily reliant on exports, will choose to peg the value of their currency to the US dollar. Although there are certain advantages to these fixed exchange rates, especially with regard to trade, there are also some negatives. Fixed exchange rates can be expensive to maintain and require a large amount of foreign exchange reserves. This constant maintenance of a currency’s value can have large economic repercussions, such as increases in price level.
Although the modern foreign exchange market has only really developed in the last half century, the concept of exchanging currencies with fluctuating values is by no means a new concept. Today, the foreign exchange market is the biggest financial market in the world and plays a significant role in the maintenance of our increasingly global economy.