6.3 The Foreign Exchange Market

a. Define the foreign exchange market, demand for currency, and supply of currency. b. Explain (using graphs as appropriate) the relationship between the exchange rate and the quantity of currency demanded (supplied).

• The demand for a currency in a foreign exchange market arises from the demand for the country’s goods, services, and financial assets and shows the inverse relationship between the exchange rate and the quantity demanded of a currency.
• The supply of a currency in a foreign exchange market arises from making payments in other currencies and shows the positive relationship between the exchange rate and the quantity supplied of a currency.
• Enduring understanding MKT-5: The interaction of buyers and sellers exchanging the currency of one country for the currency of another determines the equilibrium exchange rate in a flexible exchange market and influences the flow of goods, services, and financial capital between countries.

Define (using graphs as appropriate) the equilibrium exchange rate.

• In the foreign exchange market, equilibrium is achieved when the exchange rate is such that the quantities demanded and supplied of the currency are equal.
• Enduring understanding MKT-5: The interaction of buyers and sellers exchanging the currency of one country for the currency of another determines the equilibrium exchange rate in a flexible exchange market and influences the flow of goods, services, and financial capital between countries.

Explain (using graphs as appropriate) how exchange rates adjust to restore equilibrium in the foreign exchange market.

• Disequilibrium exchange rates create surpluses and shortages in the foreign exchange market. Market forces drive exchange rates toward equilibrium.
• Enduring understanding MKT-5: The interaction of buyers and sellers exchanging the currency of one country for the currency of another determines the equilibrium exchange rate in a flexible exchange market and influences the flow of goods, services, and financial capital between countries.