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A foreign exchange market is where one currency is traded for another. There is a demand for each currency and a supply of each currency. In these markets, one currency is bought using another. The price of one currency in terms of another (for example, how many dollars it costs to buy one Mexican peso) is called the exchange rate.
Foreign currencies are demanded by domestic households, firms, and governments that wish to purchase goods, services, or financial assets denominated in the currency of another economy. For example, if a US auto importer wants to buy a German car, the importer must buy euros. The law of demand holds: as the price of a foreign currency increases, the quantity of that currency demanded will decrease.
Foreign currencies are supplied by foreign households, firms, and governments that wish to purchase goods, services, or financial assets denominated in the domestic currency. For example, if a Canadian bank wants to buy a US government bond, the bank must sell Canadian dollars. As the price of a foreign currency increases, the quantity supplied of that currency increases.
Exchange rates are determined just like other prices—by the interaction of supply and demand. At the equilibrium exchange rate, the supply and demand for a currency are equal. Shifts in the supply or the demand for a currency lead to changes in the exchange rate. Because one currency is exchanged for another in a foreign exchange market, the demand for one currency entails the supply of another. Thus the dollar market for euros (where the price is dollars per euro and the quantity is euros) is the mirror image of the euro market for dollars (where the price is euros per dollar and the quantity is dollars).
To be concrete, consider the demand for and the supply of euros. The supply of euros comes from the following:
The demand for euros comes from the following:
Figure 31.17 "The Foreign Exchange Market" shows the dollar market for euros. On the horizontal axis is the quantity of euros traded. On the vertical axis is the price in terms of dollars. The intersection of the supply and demand curves determines the equilibrium exchange rate.
Figure 31.17 The Foreign Exchange Market
The foreign exchange market can be used as a basis for comparative statics exercises. We can study how changes in an economy affect the exchange rate. For example, suppose there is an increase in the level of economic activity in the United States. This leads to an increase in the demand for European goods and services. To make these purchases, US households and firms will demand more euros. This causes an outward shift in the demand curve and an increase in the dollar price of euros.
When the dollar price of a euro increases, we say that the dollar has depreciated relative to the euro. From the perspective of the euro, the depreciation of the dollar represents an appreciation of the euro.