Foreign Exchange Markets and Balance of Payment

Foreign Exchange Markets

In general, specialization and exchange of goods and services across national borders can be illustrated using a universal medium of exchange. However, most countries are not willing to relinquish the right to own, supply, and regulate their currency. Therefore, foreign exchange markets are necessary for the absence of the universal medium of exchange. Foreign exchange markets take care of the exchange rates of different currencies in international trade transactions. These activities are usually administered by central banks found within these markets.

The foreign exchange market exists for all currencies, such as the US dollar and the Japanese Yen. The two currencies are very important for facilitating transactions that transpire between the two countries. When American citizens purchase Japanese goods or services, they must buy the Japanese currency to facilitate such transactions. This also applies to Japanese citizens who aim to purchase (import) American products and services. The exchange rate is thus determined by the demand and supply of the two currencies in the Forex market.

The exchange rate represents the amount of one currency required to purchase another currency. For instance, it refers to the number of dollars needed to purchase one Japanese yen and vice versa. This is well illustrated in figure 1. The exchange rate also determines the prices of products and services in the respective countries. When the exchange rate favors the Japanese yen over the US dollar, American goods and services become cheaper.

This encourages more imports from the United States and vice versa. The exchange rate can be adjusted by increasing or decreasing the supply of a particular currency in the exchange rate market. Therefore, the role of the foreign exchange market is to ensconce a market-clearing exchange rate.

Balance of Payment

Balance of payment refers to the record of transactions across national borders. The balance of the payment account is normally divided into current accounts and financial accounts. The former contains the record of products and services exchanged across national borders as well as the income payments and transfers. On the other hand, financial accounts are made up of the record of foreign acquisitions of real and financial assets and local (individuals and institutions) acquisitions of similar assets.

A perfect example is shown in figure 2, in which the record of transactions between the United States and the European Union are illustrated. Figure 2 shows the balance of payments between the US and the European Union, which employs a common currency (Euro). As a result, figure 2 provides the exchange rate of the dollar versus the Euro (Euro cost of dollars). Line Dc depicts the number of dollars demanded by the European Union for the current account transactions in the United States.

On the other hand, line Sc depicts the amount of dollar supplied to the euro-dollar exchange market to purchase Euros by the Americans. In general, the total amount of payments received by the country should be equal to the total amount of leaving the country. When the demand for the dollar is higher than the supply, it means that there is a deficit. On the other hand, when the supply is higher than the demand, then there is a surplus.

At any point for €/$, the parallel distance ‘S­c-Dc‘ represents the deficit in the current account. European importers include the demand for dollar (Df) in their current account (Dc). The line ‘Dc+Df‘ represents the overall demand for dollars by European importers. On the other hand, American importers add a supply of dollars (Sf) to the country’s current account (Sc). Therefore, Line ‘Sc+Sf‘ represents the overall supply of dollars by the US government. The intersection of the demand and supply curves establishes the exchange rate.

International Gold Standard

The international gold standard was introduced in the late 19th century as a benchmark for the global exchange rate. It was used during the First and the Second World Wars to stabilize the global exchange rate. Nonetheless, there are certain conditions that a country must meet to achieve an international gold standard. First, it must express its monetary unit in terms of gold. For instance, the UK defines its monetary unit (the sterling pound) to be equivalent to 113 grains of gold.

In the same way, the United States defines its dollar to be equivalent to 23.22 grains of gold. This system is commonly referred to as the par of exchange between the monetary units. Second, they must liberalize the movement of gold in and out of the country. Last but not least, they must be willing to exchange their gold reserves for its monetary unit without limitations.

Dollar versus Yen.
Figure 1: Dollar versus Yen.
Dollar versus Euro.
Figure 2: Dollar versus Euro.
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