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By the end of this section, you will be able to:

  • Define"foreign exchange market"
  • Describe different types of investments like foreign direct investments (FDI), portfolio investments, and hedging
  • Explain how the appreciating or depreciating of currency affects exchange rates
  • Identify who benefits from a stronger currency and benefits from a weaker currency

Most countries have different currencies, but not all. Sometimes small economies use the currency of an economically larger neighbor. For example, Ecuador, El Salvador, and Panama have decided to dollarize    —that is, to use the U.S. dollar as their currency. Sometimes nations share a common currency. A large-scale example of a common currency is the decision by 17 European nations—including some very large economies such as France, Germany, and Italy—to replace their former currencies with the euro. With these exceptions duly noted, most of the international economy takes place in a situation of multiple national currencies in which both people and firms need to convert from one currency to another when selling, buying, hiring, borrowing, traveling, or investing across national borders. The market in which people or firms use one currency to purchase another currency is called the foreign exchange market    .

You have encountered the basic concept of exchange rates in earlier chapters. In The International Trade and Capital Flows , for example, we discussed how exchange rates are used to compare GDP statistics from countries where GDP is measured in different currencies. These earlier examples, however, took the actual exchange rate as given, as if it were a fact of nature. In reality, the exchange rate is a price—the price of one currency expressed in terms of units of another currency. The key framework for analyzing prices, whether in this course, any other economics course, in public policy, or business examples, is the operation of supply and demand in markets.

Visit this website for an exchange rate calculator.

The extraordinary size of the foreign exchange markets

The quantities traded in foreign exchange markets are breathtaking. A survey done in April, 2013 by the Bank of International Settlements, an international organization for banks and the financial industry, found that $5.3 trillion per day was traded on foreign exchange markets, which makes the foreign exchange market the largest market in the world economy. In contrast, 2013 U.S. real GDP was $15.8 trillion per year .

[link] shows the currencies most commonly traded on foreign exchange markets. The foreign exchange market is dominated by the U.S. dollar, the currencies used by nations in Western Europe (the euro, the British pound, and the Australian dollar), and the Japanese yen.

(Source: http://www.bis.org/publ/rpfx13fx.pdf)
Currencies traded most on foreign exchange markets as of april, 2013
Currency % Daily Share
U.S. dollar 87.0%
Euro 33.4%
Japanese yen 23.0%
British pound 11.8%
Australian dollar   8.6%
Swiss franc   5.2%
Canadian dollar   4.6%
Mexican peso   2.5%
Chinese yuan   2.2%

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Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
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