Quiz 19: International Finance and the Foreign Exchange Market

Business

If the dollar depreciates relative to the Japanese yen then this implies that more units of dollar will be needed to purchase one unit of yen. As more units of dollar are now needed to purchase one unit of yen, dollar price of Japanese goods will increase. Thus, depreciation of dollar with respect to Japanese yen will increase the dollar price of a Japanese camera produced by Nikon. As we know that when price of a commodity increases, its quantity demanded declines. So, increase in dollar price of Japanese camera produced by Nikon will make these cameras expensive for American and thus the quantity of Nikon cameras purchased by Americans will decline.

Demand for foreign exchange arises when a country purchases goods from foreigners. So, purchase of items from foreigners implies demand for foreign exchange. Supply of foreign exchange arises when foreigners purchase items from the said country. So, sale of items to foreigners implies supply of foreign exchange. As we know that foreign exchange market is in equilibrium when demand for foreign exchange equals the supply of foreign exchange. So, if foreign exchange market is in equilibrium then this implies that demand for foreign exchange is in balance with the supply of foreign exchange. This indirectly implies that purchase of items from foreigners is in balance with sales of items to foreigners. Thus, when the foreign exchange market is in equilibrium or when equilibrium exchange rate prevails, it brings the purchases of items from foreigners into balance with the sales of items to foreigners.

Under flexible exchange rate system, exchange rate is determined when the demand for foreign exchange equals the supply of foreign exchange. So, in a sense, flexible exchange rate balances out the demand for foreign exchange with supply of foreign exchange. As we know that, demand for foreign exchange arises from payment of imports of goods and services, whereas supply of foreign exchange arises from receipts from exports of goods and services. Thus, in a way, flexible exchange rate brings the payments for imports of goods and services into balance with receipts from the exports of goods and services.

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