ABSTRACT
Foreign exchange markets are necessary to facilitate trade and other transactions between countries with different currencies. This chapter examines foreign exchange markets. International business transactions typically involve two currencies. If a department store imports Italian shoes, it must exchange dollars for lira in order to pay the exporting firm. Debit entries in the U.S. balance of payments represent sales of dollars and purchases of foreign exchange. Credit entries indicate that dollars are purchased and foreign currency sold to complete the transaction. The only exception to this conclusion is when the same individual is involved in two international transactions of the same size and opposite sign. The transactions are self-canceling in their balance of payments effects and do not necessitate the use of the foreign exchange market. For example, if the department store purchases Italian shoes and pays for the imports with a check drawn on a lira account in an Italian bank, there would be no purchase of currency in the exchange market and there would be two offsetting balance of payments entries. Except for such offsetting transaction, every change in the balance of payments accounts is reflected in the exchange market. When a balance of payments surplus or deficit exists, a parallel disequilibria occurs in the exchange market. When a country experiences a balance of payments deficit, an excess supply of domestic currency (excess demand for foreign currency) exists in the exchange market. Under fixed exchange rates, the balance of payments deficit must be offset by central bank intervention, altering the level of foreign exchange reserves to clear the market. If exchange rates are floating, the adjustment process occurs automatically as the exchange rate changes to instantly restore equilibrium in the foreign currency market.
