The Foreign Exchange Market: An introduction

 What is foreign exchange rate or exchange rate?

An exchange rate is simply the price of one currency in terms of another. The process by which
that price is determined depends on the particular exchange rate mechanism adopted. In a floating
rate system, the exchange rate is determined directly by market forces, and is liable to fluctuate
continually, as dictated by changing market conditions. In a 'fixed', or managed rate system, the
authorities attempt to regulate the exchange rate at some level that they consider appropriate. Such
a system often seems appealing to those who are troubled by the uncertainties of the present, highly
volatile, floating rate environment.

But the choice of exchange rate regime involves considerations that extend beyond the stability or
otherwise of currency prices. This will become clearer after an examination of some fundamentals
of the foreign exchange market.

 Economics of the Foreign Exchange Market

In a floating exchange rate regime the price of the dollar, like any other market-determined price,
depends on the relevant forces of supply and demand. But what are the relevant forces of supply
and demand in the foreign exchange market?

To try to answer this question, let us consider, for illustration, the factors that determine the
relationship between the Australian dollar and the Japanese yen. The Japanese require dollars to
pay for their imports of goods and services from Australia and to fund any investment they may
wish to undertake in this country. Assume that they obtain these dollars on the foreign exchange
market by supplying (selling) yen in return. So the Japanese demand for dollars (mirrored by the
supply of yen) is determined by the exports to Japan and our capital inflow from that country.

On the other side of the market, the Australian demand for yen is determined by our need to pay
for imports from Japan, and for any capital investment that we undertake there. We buy those yen
 by supplying Australian dollars in return. Thus the supply of dollars (mirrored by the demand for
yen) is determined by our imports from Japan and our capital outflow to that country.

In summary, then, the demand for Australian dollars reflects the behavior of our exports and capital
inflow, while the supply of dollars reflects the behavior of our imports and capital outflow. In other
words, transactions on the foreign exchange market echo the international trade and financial
transactions that are summarized in the balance of payments. Within the balance of payments, the
relationship between our exports and imports of goods and services is captured by the balance of
current account, while the relationship between capital inflow and capital outflow is captured by
the balance of capital account. The activities of international currency speculators affect the
exchange rate directly through their impact on capital flows.

The distinguishing characteristic of a floating exchange rate system is that the price of a currency
adjusts automatically to whatever level is required to equate the supply of and demand for that
currency, thereby clearing the market. The logic of the relationship between our international
transactions and the supply and demand for currencies implies that this market-clearing, or
'equilibrium', price also produces automatic equilibrium in the balance of payments. That is, the
balance of current account (whether positive, negative, or zero) must be precisely offset by the
balance (negative, positive, or zero) of the capital account. Under floating exchange rates these
outcomes are achieved automatically without the need for government intervention. By contrast,
under fixed exchange rates balance of payments equilibrium is not the normal condition.

These characteristics of the floating exchange rate mechanism have important implications both
for the nature of our relationship with the global environment, and for the policy options available
to the authorities in managing the economy. Let us now consider some of these.

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 International Transmission of Economic Stability