Introduction
In the modern economy, firms buy and sell products from more than just local or national markets. Often a firm's supplier is located in a different country. To make purchases and sell their own goods internationally, firms need to change units of one currency for units of another currency. For instance, when a British firm trades with a U.S. firm, the U.S. firm may pay in U.S. dollars. However, the British firm needs to pay many of its costs in British pounds. When the U.S. firm pays the British firm, then, one of two things has to occur: the U.S. firm must convert its dollars to pounds and then pay the British firm in pounds, or the British firm must accept dollars from the U.S. firm and then convert the dollars into pounds to pay its workers. And, to be sure that the sum in pounds is equivalent to the sum in dollars, all parties to the transaction must know the value of dollars in terms of pounds. Now multiply this single transaction by the number of countries and firms involved in all aspects of the production of all internationally traded goods and services and one can see that multiple currencies make international trade far more complex and difficult than domestic trade.
The desire to transact internationally provides the impetus for a huge, well-functioning market that facilitates such currency conversions and allows global economic integration and trade to take place smoothly and quickly at low cost. Both by volume of trade and ease of making transactions, currency markets today are the world's deepest, most liquid markets in the world. Currency markets range from simple markets where parties simply exchange one currency for another, to sophisticated markets where parties buy and sell currency far into the future.
In 2005 the United States imported and exported over $3 trillion worth of goods and services. In addition, gross sales and purchases of long-term U.S. securities, such as corporate and Treasury bonds, to residents of foreign countries amounted to around $41 trillion. Most of these transactions either directly or indirectly required a foreign-exchange transaction. A foreignexchange transaction is a trade of any two currencies. For example, a purchase of Japanese yen with U.S. dollars is a foreign-exchange transaction.
As cross-border transactions have become larger and more frequent, foreign-exchange markets have become increasingly important to the global economy and have grown in relative size: whereas U.S. cross-border trade in goods and services and long-term securities are measured in trillions of dollars per month or year, turnover in foreign-exchange markets is measured in trillions of dollars per day. Daily average turnover in global foreign-exchange markets averaged $1.9 trillion in April 2004. (Note: Unless otherwise noted, all foreign-exchange transactions data in this chapter are from April 2004, the latest date for which global turnover data are available.)
Foreign-exchange transactions vary in size and complexity. A foreignexchange transaction is simply a trade of one country's currency for that of another, whether the amount traded is a few dollars or a few billion dollars; whether the entity making the exchange is a tourist changing money at the border for a short holiday or a foreign company building a new factory needing to exchange millions in domestic currency to pay for materials and labor; or whether the form of money being acquired is foreign currency notes, foreign currency bank deposits, or assets such as stocks or bonds denominated in foreign currency.
Key points of this chapter are:
1. Foreign-exchange markets not only allow firms to trade goods and services across borders but also allow firms to manage the risks they face from fluctuations in the price of their domestic currency.
2. As with any other good, the exchange value of a currency is determined by its supply, as well as the demand for the country's assets, goods, and services.
3. Over much of the 20th century, countries tended to favor fixed exchange rates. In recent decades, there has been a shift away from fixed regimes toward freely floating exchange rates.
4. Monetary and exchange-rate policies are tightly linked. A nation's government must decide between controlling its exchange rate and controlling its domestic inflation rate.