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Foreign exchange markets and exchange rates

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Foreign exchange markets and exchange rates

Dr. Muhannad Talib Al-Hamdi
Muhannad Talib Al-Hamdi *

The foreign exchange market is a very active market around the world. The value of exchanges in it is nearly five trillion dollars a day.

The exchange rates of the currencies that result from those exchanges are announced by many important economic and financial institutions in various countries of the world.

Banks and financial institutions around the world employ people to deal in currencies or what are called currency dealers.

They buy and sell deposits in banks instead of exchanging large amounts of fiat currencies, as banks around the world maintain deposits in different currencies depending on the country in which they operate.

For example, if a bank in France wanted to sell US dollars in order to buy Japanese yen, the bank might exchange dollar deposits it had in exchange for deposits in Japanese yen held with a bank in Germany.

But companies and individuals obtain foreign currency directly from banks and exchange agencies.

Exchange rates are determined by the currency markets all over the world.

A variety of factors can influence these exchange rates, including import and export quantities, GDP, market expectations and inflation.

For example, if the gross domestic product decreases in a particular country, then that country is likely to import less quantities and vice versa as well, causing a change in the amount of the local currency exchanged for foreign currencies.

These fluctuations also cause a shift in the currency exchange markets.

For example, if Iraq enters into a state of economic recession, the Iraqi GDP will decrease and Iraq will import less goods from the United States.

Consequently, the demand for dollars in the Iraqi market decreases and the dollar price against the dinar decreases.

In other words, the Iraqi dinar is gaining a higher price compared to the dollar.

The currency exchange market includes companies, families, and investors who buy goods, services, and foreign assets (or who sell goods, services, and assets to foreigners).

As a result, they request (or offer) foreign (or local) currencies to complete their dealings.

For example, some families buy imported goods that need foreign currencies to pay for. Likewise, wealthy individuals or companies make investments in foreign countries where they also need foreign currencies.

The exchange rate in the market is determined by the interaction of the forces of supply and demand for a particular currency, like any other commodity in the market.

And like any other currency in the world, there are three sources that determine the demand for the Iraqi dinar:

First: Foreign companies and persons (including foreign visitors) who want to buy goods and commodities produced in Iraq, including tourism activities,

Second: Foreign companies and people who want to invest in Iraq through foreign direct investment, that is, establishing and managing projects in Iraq, or through investing the foreign portfolio, that is, buying stocks and bonds that are issued by Iraqi institutions,

And third, currency dealers who believe that the price of the dinar will rise in the future compared to its price today.

When the exchange rate of the dinar is high, the quantity demanded of it decreases.

For example, when the exchange rate of a dinar is 1,200 dinars to a dollar, the quantity required to buy from it will be less than if its exchange rate was 1,450 dinars to a dollar by companies that want to buy Iraqi goods and goods, as well as for foreign investors who want to invest in the country.

For example, when a foreign person wants to buy an Iraqi commodity worth a thousand dollars, he will need to buy an amount of one million two hundred thousand Iraqi dinars according to the exchange rate of 1,200 dinars to the dollar, but he will need to buy one million and 450 thousand dinars if the exchange rate becomes 1,450 dinars to the dollar.

That is, the inverse relationship between the required quantity of the dinar and the change in the exchange rate, the lower price of the dinar leads to the purchase of larger quantities of it.

That is, the demand curve for the currency (the Iraqi dinar here) is a negatively sloping curve.

As for the supply, it is normal for there to be a positive relationship between the exchange rate and the amount of supply of the dinar.

When the exchange rate of a dinar rises, a larger amount is displayed.

When the exchange rate changes from 1,200 dinars to a dollar to 1,450 dinars to a dollar, people and institutions that own the dinar will have to offer larger amounts of it to get one dollar that you use for the purposes you want, such as buying foreign products denominated in dollars.

Therefore, the currency supply curve is positively sloping.

And like any other market, equilibrium occurs in the currency exchange market when the forces of supply and demand meet, that is, the quantity supplied is equal to the quantity demanded at the equilibrium point through which the equilibrium exchange rate is determined.

When the exchange rate in the market, for any reason, is higher than the equilibrium price, there will be a surplus of the local currency, which causes pressure to the lowest on the exchange rate, and that continues until the equilibrium price is reached.

Likewise, if the market exchange rate is lower than the equilibrium exchange rate, there will be a scarcity in the local currency, which puts upward pressure on the exchange rate until the equilibrium price is reached.

The surplus and scarcity in the currency exchange market is removed very quickly due to the huge volume of exchanges in the major global currencies and currency dealers communicate with each other in real time through the Internet.

Shifts in the supply and demand for a currency cause a change in the exchange rate.

The primary factors causing shifts in the supply and demand for a currency include, but are not limited to this:

Changes in demand for domestic products and changes in demand for foreign goods and commodities.

The change in the desire to invest in the country compared to the desire to invest outside the country.

A change in the expectations of currency dealers about the future price of the local currency versus the future price of the foreign currency.

Shifts in the supply and demand curves of a currency:

Any change in any market factor other than the exchange rate leads to shifts in the supply curve, the demand curve for the currency, or the two curves together, which leads as a result to a change in the exchange rate.

For example, if a country that is considered a trading partner of Iraq achieves significant economic growth, the incomes of families in that country will increase, and the demand for Iraqi goods and goods by the residents of that country will increase.

At a certain exchange rate, the demand for the Iraqi dinar will increase and the demand curve for the Iraqi dinar will shift to the right (i.e. the increase in demand), which will raise its exchange rate against the currency of that country.

Likewise, if the interest on deposits and bonds in Iraq increased, the demand curve for the dinar would shift to the right as the desire to invest in Iraqi financial assets increases.

Currency dealers also play an important role in the currency exchange markets because the currency exchanges they carry out increase the volume of transactions and liquidity in the market.

If currency dealers become convinced that the future price of the dinar will be lower than its current price, the demand for the dinar will now decrease, the demand curve will shift to the left, and the exchange rate of the dinar will decrease against other currencies under the condition that all other factors remain constant.

The factors that affect shifts in the currency supply curve are similar to those that affect shifts in the demand curve.

An economic growth in Iraq leads to an increase in the incomes of the families who live in it, and an increase in their demand for goods and commodities, including foreign goods and commodities, and an increase in companies' spending on the purchase of foreign raw materials to be used in their domestic production.

To achieve this, they must supply larger quantities of Iraqi dinars in order to exchange them for foreign currencies, which leads to a shift in the dinar supply curve to the right (i.e., an increase in the dinar supply).

Likewise, if the interest rate rose in the United States, for example, financial assets in that country would become more attractive to the Iraqi investor, which would make him offer more Iraqi dinars to obtain dollars to be used in the purchase of American financial assets.

Likewise, if currency dealers become convinced that the price of the Al-Masqibli dollar will be higher compared to the Iraqi dinar than its price today, the supply of the dinar will rise (i.e. turn to the right) because currency dealers will try to change the dinars that they have in dollars.

Market adjustment to arrive at a new equilibrium exchange rate

The factors affecting the forces of supply and demand for a currency are constantly changing. Whether the exchange rate changes up or down depends on shifts in the supply and demand curves.

For example, if the demand curve for the Iraqi dinar to switch dollars to the right shifts at a level greater than the shift in the supply level, this will lead to a rise in the exchange rate of the dinar against the dollar.

Changes in the exchange rate may have two types of effect on the demand for the local currency:

the wealth effect and
the exchange rate effect.

We are interested in the second type of effect.

Exchange rate movements may generate a currency substitution effect, as investor expectations play a crucial role.

If people expect that the exchange rate is likely to decline further after an initial decline (and this appears to be happening in Iraq now), they will respond to that by increasing the share of foreign assets in their holdings of funds.

This increases the supply of local currency to obtain foreign currency due to the high opportunity cost of holding the local currency, which means that the exchange rate of the local currency decreases.

Therefore, currency exchange can be used to hedge this risk.

In this regard, a lower exchange rate would reduce the demand for the local currency.

* Professor of Economics and Political Science, Kansas State University, USA.
Number of observations 138 Date of addition 01/10/2021

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