Money is any medium that is universally accepted in an economy by sellers of goods and services as payment and by creditors as payment for debts. Money serves as a medium of exchange; indeed, without money, we would have to resort to barter in doing business. Barter is simply a direct exchange of goods and services for other goods and services. For instance, a wheat farmer who wants a pair of eyeglasses must find an optician who, at exactly the same time, wants a dozen bushels of wheat; that is, there must be a double coincidence of wants, and the elements of the desired trade must be of equal value. If there is not a double coincidence of wants, the wheat farmer must go through several trades in order to obtain the desired eyeglasses; for example, this might involve trading wheat for a computer, then the computer for several lamps, then the lamps for the desired eyeglasses.
The existence of money means that individuals do not need to hold a diverse collection of goods as an exchange inventory. Money allows them to specialize in any area in which they have a comparative advantage and to receive money payments for their labor. Money can then be exchanged for the fruits of other people's labor. The use of money as a medium of exchange permits individuals to specialize and promotes the economic efficiencies that result from specialization.
In the same way that money facilitates exchange in a single economy, exchange of currencies facilitates the exchange of goods and services across the boundaries of countries. For instance, when you buy a foreign product, such as a Japanese car, you have dollars with which to pay the Japanese carmaker. The Japanese carmaker, however, cannot pay workers in dollars. The workers are Japanese, they live in Japan, and they need Japanese yen to buy goods and services in that country. There must be some way of exchanging dollars for the yen that the carmaker will accept in order to facilitate trade. That exchange occurs in a foreign-exchange market, which in this case specializes in exchanging yen for dollars.
The particular exchange rate between yen and dollars that would prevail depends on the current demand for and supply of yen and dollars (see Figure 1). If one cent per yen is the equilibrium price of yen, then that is the foreign-exchange rate determined by the current demand for and supply of yen in the foreign-exchange market. A person going to the foreign-exchange market would need one hundred yen (1/.01) to buy one dollar or one dollar to buy one hundred yen.
SUPPLY AND DEMAND FOR FOREIGN CURRENCY
Suppose you want to buy a Japanese car. To do so, you must have Japanese yen. You go to the foreign-exchange market or your American bank. Your desire to purchase the Japanese car causes you to offer supply dollars to the foreign-exchange market. Your demand for Japanese yen is equivalent to your supply of U.S. dollars to the foreign-exchange market. Indeed, every U.S. import leads to a supply of dollars and a demand for some foreign currency. Likewise, every U.S. export leads to a demand for dollars and a supply of some foreign currency by the purchaser.
For the moment assume that only two goods are being traded—Japanese cars and U.S. steel. Thus, the U.S. demand for Japanese cars creates a supply of dollars and a demand for Japanese yen in the foreign-exchange market. Similarly, the Japanese demand for U.S. steel creates
a supply of yen and a demand for dollars in the foreign-exchange market. The equilibrium exchange rate will tell us how many yen a dollar can be exchanged for (the dollar price of yen) or how many dollars a yen can be exchanged for (the yen price of dollars).
The demand for and supply of foreign-exchange determine the equilibrium foreign exchange rate. For the moment, ignore any speculative aspects of foreign exchange; that is, assume that there are no individuals who wish to buy yen simply because they think that the price of yen will go up in the future.
The idea of an exchange rate is similar to the idea of paying a market-determined price for something you want to buy. If you like soda, you know you have to pay about fifty cents a can. If the price went up to one dollar, you would probably buy fewer sodas. If the price went down to twenty-five cents, you might buy more. In other words, the demand curve for soda, expressed in terms of dollars, slopes downward, following the law of demand.
The demand curve for Japanese yen also slopes downward. Suppose it costs you one cent to buy one yen—this would be the exchange rate between dollars and yen. If tomorrow you had to pay two cents for a yen, then the exchange rate would have changed. Looking at such an increase with respect to the yen, we would say that there has been an appreciation in the value of the yen in the foreign-exchange market. But this increase in the value of the yen means that there has been a depreciation in the value of the dollar in the foreign-exchange market. When one currency appreciates, the other currency depreciates.
DETERMINANTS OF THE VALUE OF FOREIGN EXCHANGE
Supply and demand in the foreign-exchange market are determined by changes in many market variables, including relative price levels, real interest rates, productivity, product preferences, and perceptions of economic stability.
Different countries have different rates of inflation, which are an important factor in determining exchange rates. Purchasing power parity (PPP) is one widely used theory of the determination of exchange rates. PPP exists between any two currencies whenever changes in the exchange rate exactly reflect relative changes in price levels in two countries. In the long run, the average value of exchange rates depends on their purchasing power parity because in that way the relative prices in the two countries will stay the same (when measured in a common currency). That is, changes in the relative values of the two currencies compensate exactly for differences in national exchange rates. The PPP theory seems to work well in the long run when the differences in inflation rates between two countries are relatively large. When differences in inflation rates are relatively small, other market-oriented forces may dominate and often distort the picture.
A factor that may affect equilibrium currency prices is the interest rate of a country. If the U.S. interest rate, corrected for people's expectations of inflation, abruptly increased relative to interest rates in the rest of the world, international investors elsewhere would increase their demand for dollar-denominated assets, thereby increasing the demand for dollars in foreign-exchange markets. An increased demand in foreign-exchange markets, other things held constant, would cause the dollar to appreciate and other currencies to depreciate.
Another factor affecting equilibrium is a change in relative productivity. If one country's productivity increased relative to another's, the former country would become more competitive in world markets. The demand for its exports would increase, and so would the demand for its currency.
Changes in consumers' tastes also affect the equilibrium prices of currencies. If Japan's citizens suddenly developed a taste for a U.S. product, such as video games, this would increase the demand for U.S. dollars in foreign-exchange markets.
Finally, economic and political stability affect the supply of and demand for a currency, and therefore the equilibrium price of that currency. If the United States looked economically and politically more stable than other countries, more foreigners would want to put their savings into U.S. assets than in assets of another country. This would increase the demand for dollars.
Under the flexible-exchange-rate system, the equilibrium exchange rate reflects the supply and demand for the currency. Under a fixed-exchange-rate system, a country's central bank intervenes by buying or selling its currency to keep its foreign-exchange rates from changing. As with most systems in which the price of a good or service is fixed, the only way that it can remain so is for the government to intervene. Consider the two-country example above. Suppose that there were an increase in the prices of all goods and services made in the United States, including steel. The Japanese yen would now buy less steel than before. The Japanese would supply fewer yen to the foreign-exchange market and demand fewer dollars at the fixed exchange rate. However, suppose Americans continued to demand Japanese cars. In fact, they would demand more Japanese cars because, at the fixed exchange rate, the relative price of Japanese cars would fall. Americans would now supply more dollars to the foreign-exchange market and demand more yen. In the absence of intervention by a central bank, the exchange rate would change. In order to maintain the foreign-exchange price of the yen, the Japanese central bank would buy (demand) dollars and sell (supply) yen.
If the central bank did not act to support the stated foreign-exchange rate, then too much or too little of one currency would be supplied or demanded. This lack of balance (i.e., disequilibrium) in the foreign-exchange market would impede trade between the two countries and could potentially result in a black market (i.e., under-ground market or illegal trade) in the two currencies.
The only way for the United States to support the price of the dollar is to buy up excess dollars with foreign reserves—in our case, with Japanese yen. But the United States might eventually run out of Japanese yen. If this happened, it would no longer be able to stabilize the price of the dollar, and a currency crisis would result. A currency crisis occurs when a country can no longer support the price of its currency in foreign-exchange markets under a fixed-exchange-rate system. Many such crises have occurred in the past several decades when countries have attempted to maintain a fixed exchange rate that was in disequilibrium.
One alternative to a currency crisis or to continuing to try to support a fixed exchange rate is to devalue unilaterally. Currency devaluation is equivalent to currency depreciation, except that it occurs under a fixed-exchange-rate regime. The country officially lowers the price of its currency in foreign-exchange markets; this is a deliberate public action by a government following a fixed-exchange-rate policy. Revaluation is the opposite of devaluation. This occurs when, under a fixed-exchange-rate regime, there is pressure on a country's currency to rise in value in foreign-exchange markets. Unilaterally, that country can declare that the value of its currency in foreign-exchange markets is higher than it has been in the past. Currency revaluation is the equivalent of currency appreciation, except that it occurs under a fixed exchange rate regime and is mandated by the government. Managed exchange rates, sometimes referred to as dirty float, occur when a central bank or several central banks intervene in a system of flexible exchange to keep the exchange rate from undergoing extreme changes.
A well-functioning foreign-exchange market is vital for worldwide trade. In a flexible-exchange-rate system, supply of and demand for a currency determine the exchange rate. In a fixed-exchange rate system, a government imposes the exchange rate, and given the mandated exchange rate, consumers determine how much of the currency they wish to supply or demand. In a managed-exchange-rate system, the exchange rate is determined through the markets, but the central bank will intervene by buying and selling the currency in order to influence the price.
see also International Trade