International Finance and the Foreign Exchange Market

The foreign exchange market is a highly organized market in which  currencies of different countries are bought and sold. The exchange rate is the price of one national currency in terms of another. The exchange rate permits consumers in one country to translate the prices of foreign goods into units of their own currency.

When international trade takes place, it is usually necessary for one country to convert its currency to the currency of its trading partner. Imports of goods, services, and assets (both real and financial) by the United States generate a demand for foreign currency with which to pay for these items. On the other hand, exports of goods, services, and assets supply foreign currency to the exchange market because foreigners exchange their currency for the dollars needed to purchase the export items.

The value of a nation's currency on the exchange market is in equilibrium when the supply of the currency (generated by imports-the sale of goods, services, and assets to foreigners) is just equal to the demand for the currency (generated by exports-the purchasing of goods, services, and assets from foreigners).

Under a flexible rate system, if there is an excess supply of dollars (excess demand for foreign currencies) on the foreign exchange market, the value of the dollar will depreciate relative to other currencies. A depreciation will make foreign goods more expensive to U.S. consumers and U.S. goods cheaper to foreigners, reducing the value of our imports and increasing the value of our exports until equilibrium is restored. On the other hand, an excess demand for dollars (excess supply of foreign currencies) will cause the dollar to appreciate stimulating imports and discouraging exports until equilibrium is restored.

With flexible exchange rates, a nation's currency tends to appreciate when (a) rapid economic growth abroad (and slow growth at home) stimulates exports relative to imports, (b) the rate of domestic inflation is below that of the nation's trading partners, and (c) domestic real interest rates increase relative to one's trading partners. The reverse of these conditions will cause a nation's currency to depreciate.

Unanticipated restrictive monetary policy will raise the real interest rate, reduce the rate of inflation, and, at least temporarily, reduce aggregate demand and the growth of income. These factors will in turn cause the nation's currency to appreciate on the foreign exchange market. In contrast, expansionary monetary policy will result in a currency depreciation.

Fiscal policy tends to generate conflicting influences on the exchange rate. To the extent that expansionary fiscal policy (larger budget deficits) stimulates income, it promotes imports relative to exports, causing a currency to depreciate. However, to the extent expansionary fiscal policy increases the real interest rate of a nation, it causes an appreciation of a nation's currency due to an inflow of foreign investment. The analysis is symmetrical for restrictive fiscal policy.

During the period from 1944 to 197 1, most of the nations of the free world operated under a system of fixed exchange rates. Under this system, if the value of the goods, services, and capital assets exported to foreigners is less than the value of the items imported, there is an excess supply of the country's currency on the foreign exchange market. When this happens, the country must (a) devalue its currency, (b) take action to reduce imports (for example, heighten its trade barriers), or (c) pursue a restrictive macropolicy designed to increase interest rates and retard inflation. During the period when the fixed rates were in effect, corrective action taken to maintain the rates was often in conflict with the goals of maximum freedom in international markets and the macropolicy objective of full employment.

Prior to World War 1, most countries set the value of their currency in terms of gold. When trade was conducted under the gold standard, the gold stock of a nation would fall if it imported more than it exported. The decline in the stock of gold would decrease the nation's money supply, causing prices to fall and making the nation's goods more competitive on the international market. In contrast, if a nation was a net exporter, its stock of gold would rise, causing inflation and making the nation's goods less competitive on the international market. How ever, alterations in the supply of gold often caused abrupt shifts in income and employment. The gold standard was abandoned in 1914.

The balance of payments accounts record the flow of payments between a country and other countries. Transactions (for example, imports) that supply a nation's currency to the foreign exchange market are recorded as debit items. Transactions (for example, exports) that generate a demand for the nation's currency on the foreign exchange market are recorded as credit items

In aggregate, the balance of payment accounts must balance since the accounts are kept according to the principles of double-entry book keeping. Thus, (a) the current account balance plus (b) the capital ac count balance plus (c) the official reserve account balance must equal zero. However, the individual components of the accounts need not balance. A deficit in one area implies an offsetting surplus in other areas.

Under a pure flexible rate system, there will not be any official reserve account transaction. Under these circumstances, a current account deficit implies a capital account surplus (and vice versa). Interestingly, an economy offering attractive investment opportunities to foreigners will tend to run a capital account surplus, which also implies a current account deficit under a flexible rate system.

Since 1973, most countries have operated under a managed flexible rate system. It is a managed system because the major industrial nations have used their official reserve balances in an effort to moderate swings in exchange rates. Nevertheless, market forces now play the major role in the determination of exchange rates among the major industrial nations. Given the severe shocks that international markets have suffered since it was instituted in 1973, the current system appears to be working reasonably well.