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