The market for foreign exchange

Currencies are bought and sold, just like other commodities, in markets called foreign exchange markets.  The world’s three most common transactions are exchanges between the dollar and the euro (30%) the dollar and the yen (20%) and the dollar and the pound Sterling (12%).

How currency values are established depends upon whether they are determined solely in free markets, called freely floating, or determined by agreements between governments, called fixed or pegged. Like most currencies, the pound has at times been both fixed, and floating. Between 1944 and 1971, most of the world’s currencies were fixed to the US Dollar, which in turn was fixed to gold.  After a period of floating, the pound joined the European Exchange Rate Mechanism (ERM) in 1990, but quickly left in 1992, and has floated freely ever since. This has meant that its value is largely determined by the interaction of demand and supply.

The demand for currency

The demand for currencies is derived from the demand for a country’s exports, and from speculators looking to make a profit on changes in currency values.

The supply of currency

The supply of a currency is determined by the domestic demand for imports from abroad. For example, when the UK imports cars from Japan it must pay in yen (¥), and to buy yen it must sell (supply) pounds. The more it imports the greater the supply of pounds onto the foreign exchange market. A large proportion of short-term trade in currencies is by dealers who work for financial institutions. The London foreign exchange market is the World’s single largest international exchange market.

Exchange rates

The equilibrium exchange rate is the rate which equates demand and supply for a particular currency against another currency.

Example

If we assume the UK and France both produce goods that the other wants, they will wish to trade with each other. However, French producers require payment in Euros and the British producers require payments in pounds Sterling. Both need payment in their own local currency so that they can pay their own production costs in their local currency. The foreign exchange market enables both French and British producers to exchange currencies so that trades can take place.

The market will create an equilibrium exchange rate for each currency, which will exist where demand and supply of currencies equates.

Changes in exchange rates

Changes in the value of a currency like Sterling reflect changes in demand and supply. On a demand and supply graph, the price of Sterling is expressed in terms of the other currency, such as the $US.

An increase in the exchange rate

For example, an increase in exports would shift the demand curve for Sterling to the right and push up the exchange rate. Originally, one pound bought $1.50, but now buys $1.60, hence its value has risen.

Exchange rates and interest rates

Changes in a country’s interest rates also affect its currency, through its impact on the demand and supply of financial assets in the UK and abroad. For example, higher interest rates relative to other countries, makes the UK attractive the investors, and leads to an increase in the demand for the UK’s financial assets, and an increase in the demand for Sterling.

Conversely, lower interest rates in one country relative to other countries leads to an increase in supply, as speculators sell a currency in order to buy currencies associated with rising interest rates. These speculative flows are called hot money, and have an important short-term effect on exchange rates.