What are Foreign Exchange Markets

Foreign exchange markets are markets in which national currencies are bought and sold with other national currencies. In a foreign exchange market U.S. dollars may purchase British pounds, German marks, French francs, Japanese yen, etc.

Prices of foreign currency are expressed as exchange rates, the rate at which one currency can be converted into another currency. On 12 March 1997 it took $1.59 to purchase a British pound in foreign exchange markets, or, alternatively 0.6256 British pounds could purchase one U.S. dollar. Exchange rates are reported daily in large metropolitan newspapers and financial papers such as the Wall Street Journal.

Foreign exchange markets are as old as coinage itself. In the ancient world religious temples were a popular site of foreign exchange markets because the sacredness of the grounds acted to safeguard treasuries of coin. The modern term bank evolved from the moneychangers’ “bench” of the Middle Ages. Today modern communication and computers have made possible a worldwide integrated foreign exchange market where trades are conducted electronically 24 hours a day during the business week. The big players in the foreign exchange markets are the large commercial banks with foreign branches.

Under the current international monetary system, foreign exchange markets are highly competitive and exchange rates can change daily. (Between 1946 and 1971 the world was on a fixed exchange rate system, and exchange rates were pegged at certain levels by governments.) A supply of U.S. dollars is created in foreign exchange markets when Americans buy goods, or make investments, in foreign countries where dollars are not accepted. A demand for U.S. dollars is created in foreign exchange markets when the rest of the world wants to buy American goods, or make American investments, which require payment in dollars. Exchange rates fluctuate to balance supply and demand, clearing the market for U.S. dollars as foreign exchange. Markets for other currencies emerge in a similar fashion.

Exchange rates can exert strong influences on domestic economies. If the market value of the dollar appreciates relative to the Japanese yen—meaning it takes fewer dollars to purchase a yen—Japanese goods become cheaper to American consumers, increasing the importation of Japanese goods and reducing demand for domestic goods in competition with Japanese goods. If the market value of the dollar depreciates relative to the Japanese yen—meaning it takes more dollars to purchase a yen—Japanese goods become more expensive to American consumers, diminishing the importation of Japanese goods and making domestic goods more competitive. In summary, a depreciation of the dollar increases the demand for American-made goods, and an appreciation of the dollar decreases the demand for American-made goods.

Foreign exchange rates are quoted in spot rates and forward rates. The spot rate is the rate at which foreign currency can be purchased for delivery within two business days. A forward rate is the rate at which a foreign currency can be purchased for delivery after a length of time, such as 90 days. A forward market enables an American importer to strike a deal to import French goods and purchase French francs to pay for the goods when they arrive at some date in the future, protecting the importer from fluctuations in exchange that could make the goods much more expensive than expected.

Unless the world adopts a common currency, foreign exchange markets will remain a vital part of the international trade framework, the connecting link that allows trade between countries with different currencies. On 1 January 1999 Europe launched the euro, a European currency that will eventually replace German marks, French francs, Swiss francs, and other European currencies, and will abolish the need for foreign exchange markets to establish rates for the convertibility of one European currency into another. If the world follows the path of economic integration followed in Europe, then a world currency could become a reality some day.

On the upside a world currency would remove the risk and uncertainty of exchange rate fluctuations that can disturb the flow of international trade, and promote trade between the regions of the world. On the downside a world currency would preclude the use of localized monetary policies to help specific areas. Currently, the Japanese economy is stagnant and the Bank of Japan is free to expand the Japanese money supply to stimulate the economy.

If the world was on a worldwide currency system, and Japan was the only country suffering stagnation, world monetary authorities could not expand the money supply worldwide just to help Japan—and besides, increasing the money supply worldwide might not help Japan anyway.