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Introduction to Exchange Rates and the Foreign Exchange Market
This chapter develops basic concepts about foreign exchange markets. It begins by defining nominal exchange rates. It provides a taxonomy of exchange rate regimes. Next it describes types of foreign exchange contracts and the actors in the market. Then it explains spot arbitrage, and then applies the arbitrage argument to interest rates.
The chapter on the Fall of the Rupee you may omit. It is somewhat too sensational.
Miss Prism, in Oscar Wilde’s The Importance of Being Earnest, 1895
The people who benefit from roiling the world currency market are speculators and as far as I am concerned they provide not much useful value.
Paul O’Neill, U.S. Secretary of the Treasury, 2002
1. Example of how the exchange rate affects the choice of where to go on vacation
2. Exchange rates affect international trade in goods, services, and assets.
3. They have important macroeconomic effects
4. This chapter will:
a. Define what exchange rates are
b. Describe their empirical behavior
c. Discuss the participants of exchange markets
d. Look in detail at how they work, emphasizing arbitrage and expectations
Every few years, George, an American, takes a vacation in Paris. To make purchases in Paris, he buys foreign currency, or foreign exchange. He can purchase euros, the currency used in France, by trading his U.S. dollars for euros in the market for foreign exchange at the prevailing market exchange rate. In 2003, 1 euro could be purchased for $1.10, so the €100 he spent on a night at the hotel cost him $110 in U.S. currency. In 2007, 1 euro cost $1.32, so each night at the same hotel (where the room price hadn’t changed) made a $132 dent in his vacation budget. In 2012, the cost of 1 euro had fallen back a little to $1.25: not as high as in 2007, but still expensive enough in dollar terms to make George think about vacationing in northern California, where he might find equally good hotels, restaurants, fine food, and wine at prices that were more affordable.
Tourists like George are not the only people affected by exchange rates. Exchange rates affect large flows of international trade by influencing the prices in different currencies of the imported goods and services we buy and the exported goods and services we sell. Foreign exchange also facilitates massive flows of international investment, which include the direct investments made by multinationals in overseas firms as well as the stock and bond trades made by individual investors and fund managers seeking to diversify their portfolios.
Individual foreign exchange transactions are far removed from deep macroeconomic and political consequences. In the aggregate, however, activity in the foreign exchange market can be responsible for “sensational” events (and we are not being ironic as was Oscar Wilde in the chapter opening quote) and can arouse strong passions (Paul O’Neill is only one of many to criticize the activities of foreign exchange traders). In the foreign exchange market, trillions of dollars are traded each day and the economic implications of shifts in the market can be dramatic. In times of crisis, the fates of nations and their leaders seem to hang, in part, on the state of the currency market. Why is that so?
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In this chapter, we begin to study the nature and impact of activity in the foreign exchange market. We first survey exchange rate basics: the key definitions of exchange rates and related concepts. We then examine the evidence to see how exchange rates behave in the real world and establish some basic facts about exchange rate behavior that require explanation. We next look at the workings of the foreign exchange market, including the role of private participants, as well as interventions by governments. Finally, we look in detail at how foreign exchange markets work, and we emphasize two key market mechanisms: arbitrage and expectations.