14 - The Foreign Exchange Market

Abstract

This chapter focuses on the foreign exchange market. The exchange rate is the conversion ratio between two currencies: it tells the ratio at which they can be evenly traded. It also gives the price of foreign currency. Foreign currencies are demanded because they can be used to buy foreign goods and services. The demand for foreign exchange is called a derived demand. As the price of foreign goods depends on the exchange rate, the quantity of foreign currencies demanded changes with the exchange rate. Foreign currencies are supplied by the residents of other countries. Many factors can cause exchange rates to change, including changing tastes and preferences for foreign goods and changing comparative advantage throughout the world. Governments can control the exchange rate through foreign exchange market intervention. Between 1946 and 1973, a period of fixed exchange rates prevailed when intervention acted to stabilize exchange rates. Intervention can be difficult, however, and is not necessarily a long-run solution to fluctuating exchange rates.