Currency Exchange Markets

Because different countries use their own currencies, international trade necessitates an international trade in currency. Businesses within a country trade primarily in that country's currency and pay their domestic staff and taxes in their home country. For this reason, foreign companies wishing to purchase goods made by American companies must first possess the U.S. dollars to pay for those goods. The purchaser must enter an international currency exchange to purchase the necessary dollars before they can complete their purchase of U.S. goods. Additionally, tourists change their currency when visiting a country, as do currency traders, investors, and speculators. The rate of exchange when one currency is exchanged for another, for instance from pounds sterling to U.S. dollars, is called the foreign exchange rate. The flexible (or floating) exchange rate, where the exchange rate is based on supply and demand of the currency, is not static; however, fixed rates, which are set partially or entirely by government mandate, are static (although occasionally reset). This section addresses flexible (known as floating) foreign exchange rates.

Floating foreign exchange rates are constantly in flux. Demand for foreign currency can be increased by several factors, such as lowering the price of foreign goods or increasing domestic incomes. For example, if China produces and sells cars for a much lower cost, it would be in the interest of other nations to import cars from China rather than produce cars domestically. Therefore, demand for Chinese currency will increase so that foreign nations can purchase cars. This will increase the exchange rate in favor of the yuan renminbi (Chinese currency). Higher interest rates encourage foreign business investments: businesses will invest where interest rates are higher because there will be a higher return on investment. This will lead to an increase in demand for that country's currency. These instances of increased demand cause the value of the desired currency to undergo appreciation of currency, or an increase in a currency's value determined by the amount of foreign currency it buys. Depreciation of currency, on the other hand, is a decrease in a currency's value. It results when the supply of a given currency increases relative to another currency. For example, foreign nations are interested in purchasing a large number of U.S. goods. Once they use the U.S. dollar to purchase said U.S. good, the supply of the U.S. dollar in the hands of U.S. producers has greatly increased. Therefore, the dollar will depreciate in value and has less purchasing power abroad. Supply and demand for currency do not affect only the foreign exchange rate. Changes in the supply and demand of currency can themselves have major implications for international trade and domestic production. The value of a given currency is sometimes expressed in terms of its "strength." A strong dollar is more valuable in relation to other currencies, while a weak dollar is less valuable. When the dollar becomes strong relative to a foreign currency, goods from the foreign country become less expensive for Americans to buy. This encourages the import of foreign-made goods. As many basic goods such as food and clothes are now made overseas, a strong dollar generally benefits U.S. consumers. A weak dollar relative to a foreign currency, conversely, discourages imports because it causes foreign goods to appear more expensive to American buyers. International trade activity causes currencies to appreciate and depreciate over time in a market structure. A strong currency leads to a demand for weaker currencies so that consumers can purchase goods and services from the countries with weaker currencies. This demand leads to an increase in value of the previously weaker currency, which then becomes a strong currency with the aforementioned increase in value.