Lesson summary: the foreign exchange market (article) | Khan Academy (2024)

The foreign exchange market is like any other market insofar as something is being bought and sold. However, the foreign exchange market is unique in two ways:

1. A currency is being bought and sold, rather than a good or service
2. The currency being bought and sold is being bought with a different currency.

When the exchange rate of a currency increases, other countries will want less of that currency. When a currency appreciates (in other words, the exchange rate increases), then the price of goods in the country whose currency has appreciated are now relatively more expensive than those in other countries. Since those goods are more expensive, less is imported from those countries, and therefore less of that currency is needed.

For example, suppose the price of a cell phone in the U.S. is $\mathrm{\$}400$‍, and the current exchange rate in Japan is 90 ¥ per dollar. That means that it takes: $90\times \mathrm{\$}400=\mathrm{36,000}\yen$‍ to buy the same cell phone in Japan. If two cell phones are imported into Japan, then a total of 800 US dollars will be needed to buy these phones.

However, if the dollar appreciates so that it now takes $100\yen$‍ to buy a dollar, the same cell phone now costs $100\times \mathrm{\$}400=\mathrm{40,000}\yen$‍. Because cell phones are more expensive, only one is imported into Japan from the United States, so the quantity of US dollars that Japan wants will fall from $\mathrm{\$}800USD$‍ to $\mathrm{\$}400USD$‍.

As in any market, the foreign exchange market will be in equilibrium when the quantity supplied of a currency is equal to the quantity demanded of a currency. If the market has a surplus or a shortage, the exchange rate will adjust until an equilibrium is achieved.

For example, suppose Westeros is a trading partner of Hamsterville, and the currency of Westeros is the Westeros Gold Dragon ($WGD$‍). Currently, the exchange rate is $20WGD$‍ per Hamsterville snark ($SN$‍). At this exchange rate, Hamsterville wants to sell $100SN$‍, but Westeros only wants to buy $30SN$‍. Therefore, there is a surplus of $SN$‍.

Like any surplus, this will place downward pressure on the price. If the exchange rate is flexible, then the exchange rate will decrease until the quantity supplied is equal to the quantity demanded.

Suppose the United States and Japan are trading partners. Japan’s currency is the Yen ($\yen$‍) and United States’ currency is the U.S. dollar ($USD\mathrm{\$}$‍). We can represent the market for the U.S. Dollar in the foreign exchange market, as shown here:

• We are used to thinking about buying things with a currency, so many new learners are confused about what the price should be in the market for a currency. Buthe price of an orange is never given in oranges; it’s given in some other currency. Just like an orange, a dollar can’t be bought with itself, but instead it needs to be bought with some other currency.

• A common misperception is to confuse 1) the things that cause shifts in the supply or demand of a currency with 2) changes in quantity supplied or quantity demanded. To keep this straight, ask yourself “why is this change happening?” If a change is happening in response to a change in the exchange rate, then you are moving along a curve. If a change is happening in response to something else, the entire curve shifts.

• It might seem like a time saver to take short-cuts on labeling graphs, but this is never a good idea. Take your time labeling the foreign exchange market carefully using the elements of a market:

• Demand - the demand for the currency that is being exchanged

• Supply - the supply of the currency that is being exchanged
• Quantity - the quantity of the currency that is being exchanged
• Price - some other currency that is being used to buy the currency that is being exchanged

• China and Ghana are major trading partners. The currency of China is the $yuan$‍ and the currency of Ghana is the $cedi$‍. In a correctly labeled graph of the foreign exchange market for the cedi, show the impact of an increase in imports from Ghana to China. Then, explain what is going on in your graph.

• List 3 things that would cause the exchange rate of the U.S. dollar, in terms of Yen, to increase.