APMacro: Foreign Exchange

People, firms and nations exchange products for money and use the money to buy other products or to pay for the use of resources. Within an economy, prices are stated in the domestic currency, such as U.S. dollars or European euros. Buyers use their currency to purchase goods. International markets are different. Producers in other countries who export goods want to be paid in their own currencies so they can carry out transactions. As a result, a foreign exchange market develops where national currencies can be exchanged. Such markets serve the need of all international buyers and sellers. The equilibrium prices in these markets are called exchange rates. An exchange rate is the rate at which the currency of one nation is exchanged for the currency of another.

When Americans buy more foreign goods, U.S. dollars are sold in the international currency market to purchase foreign currencies that are used to pay producers in their own domestic currencies. Supply and demand graphs are used to demonstrate such transactions. If the demand for a currency increases, the currency appreciates or strengthens in value. Currencies sold to purchase other monies depreciate or weakens in value.

Consider the following situation. The prices of U.S. goods rise relative to the prices of German goods. What will happen as a result to trade between the United States and Germany?

Foreign Exchange

Americans will demand less expensive German goods, thereby increasing the demand for euros and supplying more dollars to the foreign exchange market. The U.S. dollar depreciates. The euro appreciates.



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