Like any market, the foreign exchange market works with two variables -- price and quantity. The quantity exchanged is one of the two currencies and the price is then specified in terms of the other currency. In the foreign exchange market for U.S. dollars and British pounds, British pounds are the quantity exchanged and the price is then specified as U.S. dollars per British pound. Alternatively this market can be viewed from the other side of the exchange such that U.S. dollars are the quantity exchanged and the price is specified as British pounds per U.S. dollar.

The exchange of currencies through foreign exchange markets is needed, in part, to facilitate the international trading of goods and services. When nations import and export goods and services they also need to exchange domestic currencies for foreign currencies. The import purchase of a Japanese car by a U.S. consumer requires that U.S. dollars (the currency used by the U.S. consumer for the initial purchase) be exchanged for Japanese yen (the currency used to pay Japanese resources for the production).

However, in addition to international trade, foreign exchange markets also facilitate the flow of capital investment among countries. Should a Japanese investor, for example, seek to purchase or construct capital goods in the United States, then Japanese yen needs to be exchanged for U.S. dollars.

Trading Currency

A Foreign Exchange Market

Any international trading, international investing, or other international financial interaction between these two countries requires the exchange of csonds and queolds.

The exhibit to the right graphically illustrates the foreign exchange market for csonds and queolds. With this particular representation, the quantity is specified as csonds and the price is specified as queolds per csond. This representation is useful if Northwest Queoldiola seeks to import goods from Csonda, an action that requires the exchange of queolds for csonds. That is, Northwest Queoldiolan importers purchase Csondan currency to enable the subsequent purchase of Csondan goods and services.

Make note that the focus of this foreign exchange market can be transposed to Northwest Queoldiolan queolds by measuring queolds as the quantity on the horizontal axis and stating the price as csonds per queolds on the vertical axis. Doing so illustrates that any given foreign exchange market is really two markets in one -- a market for each currency. That is, the foreign exchange market for csonds is the "other side of the coin" for the foreign exchange market for queolds.

Like any market, this one is comprised of a negatively-sloped demand curve (D) and a positively-sloped supply curve (S). Let's take a closer look at each.

Demand Curve

• Exporters: At the top of the list is anyone seeking to export Northwest Queoldiolan goods, especially the good citizens of Csonda who purchase Queoldiolan sundials. These exporters need queolds to purchase Queoldiolan goods from Queoldiolan producers.


• Investors: Another important group includes those wanting to purchase Queoldiolan financial or physical capital assets. If, for example, OmniComglomerate, Inc. (a well-known, multinational corporation located in Shady Valley, U.S.A.) wants to purchase a soft drink bottling plant in Northwest Queoldiola, then it must obtain queolds to complete this investment.


• Speculators: A third key source of demand is financial speculators who regularly buy and sell different currencies (as well as other financial assets). They are motivated in this activity like any financial investment -- to buy low and sell high. They purchase a given currency today in hopes that its price will rise tomorrow.

Supply Curve

Before getting to the specific list, a quick answer to this question is that sellers are merely buyers of other currencies. The act of demanding one currency necessarily involves the supply of another currency. Those who demand queolds, for example, supply csonds or another currency. As such, the list of suppliers is essentially the same as the list of demanders.

• Importers: At the top of this list are the Northwest Queoldiolans who import goods from other countries (such as Csonda). To import goods from other countries, these buyers must trade their domestic currency (queolds) for the currency used by the other nation.


• Investors: Much like demand, businesses and investors seeking to purchase financial or physical capital assets contribute to the supply of queolds. However, in this case it is Northwest Queoldiolan investors who are undertaking foreign investment, the purchase of capital goods in other countries. Like Northwest Queoldiolan importers, these investors need to trade their domestic currency for the foreign currency.


• Speculators: Lastly, financial speculators are a source of supply just as they are a source of demand. When these folks buy a currency anticipating a higher price, then they are a source of demand. However, when they sell that currency, presumably after the price has risen, then they are a source of supply.

Equilibrium Price and Quantity

Equilibrium

On the surface, equilibrium in this foreign exchange market is much like that in any market. Equilibrium is achieved at the intersection of the demand and supply curves. The equilibrium price is 0.2 csonds per queold and the equilibrium quantity of 500 queolds. Click the [Equilibrium] button to highlight this intersection.

The price is the currency exchange rate between queolds and csonds. An exchange rate of 0.2 csonds per queold also implies an exchange rate of 5 queolds per csond. Or stated in other terms, the exchange rate between queolds and csonds is at a rate of 5 to 1. Exchange rates, as much as anything, reflect the relative values of each currency, which depend on the productivities of each country and the quantities of currency available. The 5 to 1 exchange rate indicates that five times as many queolds are in circulation and thus each csond can purchase goods that are five times more valuable.

The equilibrium quantity of queolds, taken in conjunction with the equilibrium exchange rate, provides a bit of insight into csonds. If 500 queolds are exchanged for csonds at a rate of 5 to 1, then the other side of this exchange involves 100 csonds. In other words, the foreign exchange market for queolds also indicates the equilibrium for the foreign exchange market for csonds. The equilibrium exchange rate in the foreign exchange market for csonds is 5 queolds per csond and the equilibrium quantity of csonds exchanged is 100.

Two Markets in One

If, for the sake of argument, the exchange rate is 0.2 csonds per queold in this foreign exchange market for queolds, then the exchange rate is also 5 queolds per csond in the foreign exchange market for csonds. That is, 1 csond is traded for 5 queolds, however you might want to state the trade. In fact, these two foreign exchange markets are really one and the same -- csonds for queolds, queolds for csonds.

Exchange Rate Policies

• Flexible Exchange Rate: A flexible exchange rate, also termed floating exchange rate, is an exchange rate determined through the unrestricted interaction of supply and demand in the foreign exchange market. A flexible exchange rate means that a country is NOT trying to manipulate currency prices to achieve some change in the exports or imports. This policy is based on the presumption that the free interplay of market forces is most likely to generate a desireable pattern of international trade.


• Fixed Exchange Rate: A fixed exchange rate is an exchange rate that is established at a specific level and maintained through government actions (usually through monetary policy actions of a central bank). To fix an exchange rate, government must be willing to buy and sell currency in the foreign exchange market in whatever amounts are necessary to keep the exchange rate fixed. A fixed exchange rate typically disrupts the balance of trade and balance of payments for a country. But in many cases, this is exactly what a country is seeking to do.


• Managed Flexible Exchange Rate: A managed flexible exchange rate, what is also termed a managed float, is an exchange rate that is generally allowed to adjust due to the interaction of supply and demand in the foreign exchange market, but with occasional intervention by government. Most nations of the world currently use a managed flexible exchange rate policy. With this alternative an exchange rate is free to rise and fall, but it is subject to government control if it moves too high or too low. With managed float, the government steps into the foreign exchange market and buys or sells whatever currency is necessary keep the exchange rate within desired limits.