The Foreign Exchange Market: Study Guide (Macroeconomics 6.3)

What the foreign exchange market is

When people in one country buy from another country, they usually need the seller’s currency. A café in one country that imports coffee beans must pay the grower in the grower’s currency. A pension fund that buys foreign shares must pay in the currency of the stock market. These trades happen in the foreign exchange market: the market in which one currency is exchanged for another.

The price in this market is the exchange rate: the price of one currency measured in units of another. In this topic the exchange rate is flexible (floating). That means it is set by the buyers and sellers of the currency, like the price of apples in a market, not by a government.

You met appreciation and depreciation in Topic 6.2. A quick reminder:

• A currency appreciates when it buys more of the other currency than before.
• A currency depreciates when it buys less of the other currency than before.
• When one currency appreciates against a second, the second depreciates against the first.

Our fictional economies: Valdoria and Ostria

Valdoria is a fictional country whose currency is the valda (VD). Its main trading partner is Ostria, another fictional country, whose currency is the ostro (OS). All prices, quantities and exchange rates on this page are fictional.

We will study the market for valdas. Read this sentence twice, because it fixes every label on the graph:

• The good being traded is the valda, so the horizontal axis is the quantity of valdas.
• The price of a valda is measured in ostros, so the vertical axis is the exchange rate in ostros per valda (OS per VD).

A move up the vertical axis means each valda buys more ostros: the valda appreciates. A move down means the valda depreciates.

Who demands valdas?

The demand for valdas comes from anyone who wants to buy something that is priced in valdas. To get valdas they must offer ostros (or another currency). The main sources are:

• Valdorian goods and services (Valdoria’s exports). An Ostrian shop that imports Valdorian rugs must pay the weavers in valdas.
• Travel and other services. Ostrian tourists need valdas for hotels and meals in Valdoria.
• Valdorian financial assets. An Ostrian investor who buys Valdorian government bonds, shares in a Valdorian firm or a Valdorian bank deposit needs valdas.

So the demand for a currency is a derived demand: it comes from the demand for the country’s goods, services and financial assets.

Why the demand curve slopes downward. Suppose the valda depreciates from OS 2.0 to OS 1.6 per valda. A Valdorian rug that costs VD 240 used to cost an Ostrian buyer 240 × 2.0 = OS 480. Now it costs 240 × 1.6 = OS 384. The rug’s valda price has not changed, but it is 20% cheaper in ostros. Ostrians buy more Valdorian rugs, holidays and assets, and they need more valdas to pay for them. A lower exchange rate means a larger quantity of valdas demanded: an inverse relationship.

Who supplies valdas?

The supply of valdas comes from people who hold valdas and want to pay for something priced in another currency. To get ostros they must offer valdas. The main sources are:

• Imports. A Valdorian importer of Ostrian bicycles must pay the Ostrian factory in ostros.
• Travel abroad. Valdorian tourists need ostros in Ostria.
• Foreign financial assets. A Valdorian who buys Ostrian bonds or shares needs ostros.

In each case, Valdorians supply valdas in order to demand ostros.

Why the supply curve slopes upward. Suppose the valda appreciates from OS 2.0 to OS 2.5 per valda. An Ostrian bicycle priced at OS 300 used to cost a Valdorian 300 ÷ 2.0 = VD 150. Now it costs 300 ÷ 2.5 = VD 120. Foreign goods, holidays and assets are cheaper in valdas, so Valdorians buy more of them and offer more valdas in exchange. A higher exchange rate means a larger quantity of valdas supplied: a positive relationship.

Equilibrium, surplus and shortage

The equilibrium exchange rate is the rate at which the quantity of valdas demanded equals the quantity of valdas supplied. At that rate, every valda that someone wants to sell finds a buyer.

If the rate is above equilibrium, valdas are “too expensive”. The quantity supplied is greater than the quantity demanded: there is a surplus of valdas. Sellers who cannot find buyers accept fewer ostros per valda. The rate falls, so the valda depreciates, until the surplus disappears.

If the rate is below equilibrium, valdas are “too cheap”. The quantity demanded is greater than the quantity supplied: there is a shortage of valdas. Buyers compete for the scarce valdas and offer more ostros per valda. The rate rises, so the valda appreciates, until the shortage disappears.

In a flexible market these forces work without any government action. Movements toward equilibrium are movements along the curves; neither curve shifts.

Worked example 1: finding the equilibrium exchange rate

Question. The table shows the market for valdas each month (quantities in millions of valdas).

Exchange rate (OS per VD)	Quantity of valdas demanded	Quantity of valdas supplied
1.0	140	40
1.5	120	70
2.0	100	100
2.5	80	130
3.0	60	160

(a) Find the equilibrium exchange rate and quantity. (b) Describe the market at OS 2.5 per valda and explain what happens next. (c) Do the same at OS 1.5 per valda. (d) How many ostros change hands each month at equilibrium, and what is one ostro worth in valdas?

(a) Quantity demanded equals quantity supplied at OS 2.0 per valda, where 100 million valdas are traded each month.

(b) At OS 2.5 the quantity supplied (130 million) is greater than the quantity demanded (80 million). There is a surplus of 130 − 80 = 50 million valdas. Holders of valdas who want ostros cannot find buyers, so they accept a lower rate. The valda depreciates toward OS 2.0. As it falls, quantity demanded rises and quantity supplied falls until they are equal.

(c) At OS 1.5 the quantity demanded (120 million) is greater than the quantity supplied (70 million). There is a shortage of 120 − 70 = 50 million valdas. Buyers bid up the price of the valda, so it appreciates toward OS 2.0.

(d) Each valda trades for OS 2, so 100 million × 2 = OS 200 million change hands each month. One ostro is worth 1 ÷ 2 = VD 0.50.

Check. Both the surplus and the shortage are measured as a quantity of valdas (a horizontal distance on the graph), not as a gap in exchange rates.

Worked example 2: explaining the slopes with prices

Question. (a) An Ostrian chain sells Valdorian rugs priced at VD 240. Explain, using the rug’s ostro price, what happens to the quantity of valdas demanded when the valda depreciates from OS 2.0 to OS 1.6 per valda. (b) A Valdorian shop sells Ostrian bicycles priced at OS 300. Explain what happens to the quantity of valdas supplied when the valda appreciates from OS 2.0 to OS 2.5 per valda. (c) By what percentage do the valda and the ostro change in value in part (b)?

(a) At OS 2.0 a rug costs Ostrians 240 × 2.0 = OS 480. At OS 1.6 it costs 240 × 1.6 = OS 384, which is 20% cheaper. Ostrians buy more rugs. Suppose the chain’s orders rise from 5,000 to 6,000 rugs a month. It then needs 6,000 × 240 = VD 1,440,000 instead of 5,000 × 240 = VD 1,200,000. The lower exchange rate has raised the quantity of valdas demanded: a movement down along the demand curve.

(b) At OS 2.0 a bicycle costs Valdorians 300 ÷ 2.0 = VD 150. At OS 2.5 it costs 300 ÷ 2.5 = VD 120. Imports are cheaper in valdas, so Valdorians buy more. Suppose sales rise from 1,000 to 1,400 bicycles a month. The shop supplies 1,000 × 150 = VD 150,000 at the old rate and 1,400 × 120 = VD 168,000 at the new rate. The higher exchange rate has raised the quantity of valdas supplied: a movement up along the supply curve.

(c) The valda rises from 2.0 to 2.5 ostros: (2.5 − 2.0) ÷ 2.0 × 100 = 25% appreciation. One ostro was worth 1 ÷ 2.0 = VD 0.50 and is now worth 1 ÷ 2.5 = VD 0.40: (0.40 − 0.50) ÷ 0.50 × 100 = 20% depreciation of the ostro.

Check. The two percentages are not equal, because each is measured from a different starting value. The directions must always be opposite.

Two markets, one set of trades

Every trade in the market for valdas is also a trade in the market for ostros. When a Valdorian importer sells valdas to get ostros, she supplies valdas and demands ostros at the same time. So:

• The supply of valdas matches the demand for ostros.
• The demand for valdas matches the supply of ostros.
• The exchange rates are reciprocals: if one valda is worth OS 2.0, one ostro is worth VD 0.50.
• A surplus of valdas goes with a shortage of ostros, and the valda depreciating is the same event as the ostro appreciating.

On an exam, decide which currency’s market you are drawing before you label anything. If the question asks about the ostro, the horizontal axis is the quantity of ostros and the vertical axis is valdas per ostro.

Scope note. This topic covers flexible exchange rates and movements along the curves. What causes the curves to shift (tastes, incomes, price levels, interest rates, trade barriers, fiscal and monetary policy) is Topic 6.4. Fixed exchange rates set by a government are not part of this topic.

Common misconceptions

• “Valdorians demand valdas.” In the foreign exchange market the demand for valdas comes from people paying for Valdorian goods, services and assets with another currency, mainly foreigners. Valdorians usually supply valdas, to buy foreign things.
• Wrong axis labels. In the market for valdas, the vertical axis is the price of a valda in the other currency (OS per VD), not “price” or “VD per OS”. The horizontal axis is the quantity of valdas.
• “A surplus pushes the rate up.” A surplus means the currency is overpriced, so the rate falls (depreciation). A shortage pushes it up (appreciation).
• “A change in the exchange rate shifts the demand curve.” A change in the currency’s own price causes a movement along the curves. Only other factors shift them (Topic 6.4).
• “Appreciation of one currency means the other currency appreciates too.” The two move in opposite directions.
• “The percentage changes are equal.” A 25% appreciation of the valda is a 20% depreciation of the ostro.
• Measuring a surplus vertically. A surplus or shortage is a quantity of currency: the horizontal gap between the curves at a given rate.

Where this leads

Next, in Topic 6.4, Effect of Changes in Policies and Economic Conditions on the Foreign Exchange Market, you will shift these curves and see how tastes, incomes, inflation, interest rates, trade barriers and fiscal and monetary policy change the equilibrium exchange rate. Try the practice questions now, then use the revision notes and the checklist to consolidate.