Key Terms

Key Terms

appreciating when a currency is worth more in terms of other currencies; also called “strengthening” arbitrage the process of buying a good and selling goods across borders to take advantage of international price differences depreciating when a currency is worth less in terms of other currencies; also called “weakening” dollarize a country that is not the United States uses the U.S. dollar as its currency floating exchange rate a country lets the exchange rate market determine its currency's value foreign direct investment (FDI) purchasing more than ten percent of a firm or starting a new enterprise in another country foreign exchange market the market in which people use one currency to buy another currency hard peg an exchange rate policy in which the central bank sets a fixed and unchanging value for the exchange rate hedge using a financial transaction as protection against risk international capital flows flow of financial capital across national boundaries either as portfolio investment or direct investment merged currency when a nation chooses to use another nation's currency portfolio investment an investment in another country that is purely financial and does not involve any management responsibility purchasing power parity (PPP) the exchange rate that equalizes the prices of internationally traded goods across countries soft peg an exchange rate policy in which the government usually allows the market to set the exchange rate, but in some cases, especially if the exchange rate seems to be moving rapidly in one direction, the central bank will intervene Tobin taxes see international capital flows

Key Concepts and Summary

16.1 How the Foreign Exchange Market Works

In the foreign exchange market, people and firms exchange one currency to purchase another currency. The demand for dollars comes from those U.S. export firms seeking to convert their earnings in foreign currency back into U.S. dollars; foreign tourists converting their earnings in a foreign currency back into U.S. dollars; and foreign investors seeking to make financial investments in the U.S. economy. On the supply side of the foreign exchange market for the trading of U.S. dollars are foreign firms that have sold imports in the U.S. economy and are seeking to convert their earnings back to their home currency; U.S. tourists abroad; and U.S. investors seeking to make financial investments in foreign economies. When currency A can buy more of currency B, then currency A has strengthened or appreciated relative to B. When currency A can buy less of currency B, then currency A has weakened or depreciated relative to B. If currency A strengthens or appreciates relative to currency B, then currency B must necessarily weaken or depreciate with regard to currency A. A stronger currency benefits those who are buying with that currency and injures those who are selling. A weaker currency injures those, like importers, who are buying with that currency and benefits those who are selling with it, like exporters.

16.2 Demand and Supply Shifts in Foreign Exchange Markets

In the extreme short run, ranging from a few minutes to a few weeks, speculators who are trying to invest in currencies that will grow stronger, and to sell currencies that will grow weaker influence exchange rates. Such speculation can create a self-fulfilling prophecy, at least for a time, where an expected appreciation leads to a stronger currency and vice versa. In the relatively short run, differences in rates of return influence exchange rate markets. Countries with relatively high real rates of return (for example, high interest rates) will tend to experience stronger currencies as they attract money from abroad, while countries with relatively low rates of return will tend to experience weaker exchange rates as investors convert to other currencies.