Curiosity 15.1: Where Is the Foreign Exchange Market?
The foreign exchange market is the largest financial market in the world, with a trading volume of well over one trillion dollars per day. The vast majority of these trades are undertaken for speculative purposes, rather than to finance exports and imports, with the average size of a trade about $6 million. About 80 percent of these trades involve the U.S. dollar, about 29 percent of which are in German marks and 18 percent of which are in Japanese yen. No other single currency is involved in more than 6 percent of the U.S. dollar trades. This market does not have any single location trades are made by phone or electronically in several markets around the world at all hours of the day. About 30 percent of the trading takes place in the United Kingdom; about 16 percent takes place in the United States.
A balance of payments surplus occurs when the demand for our dollars on the foreign exchange market exceeds the supply. A balance of payments deficit is the opposite a situation in which the supply of dollars exceeds its demand. Be careful here! In most supply-and-demand diagrams a surplus occurs when supply exceeds demand. If you wish, think of a balance of payments surplus as a surplus of foreign currency flowing into our country.
15.2 Determinants of Foreign Exchange Market Activity
Balance of payments surpluses and deficits arise from changes in the supply of and demand for our dollar on the foreign exchange market. Several variables affect supply and demand activity in this market:
1. Exchange rate. The price or value of our dollar in terms of foreign exchange, called the exchange rate, is determined in the foreign exchange market. If, for example, a dollar can buy five French francs, the exchange rate is five francs per dollar. A balance of payments surplus means that demand for our dollar on the foreign exchange market exceeds its supply, so the price of the dollar (the exchange rate) will be bid up, say to six francs per dollar. The dollar is now more valuable; it buys six instead of five francs. This stronger dollar makes imports cheaper for U.S. citizens, so imports increase thus increasing the supply of dollars on the foreign exchange market. Similarly, our exports are more expensive to foreigners so exports fall, decreasing the demand for dollars on the foreign exchange market. In this way, the rise in the exchange rate eliminates the balance of payments surplus. The opposite occurs when we have a balance of payments deficit: the exchange rate falls to eliminate the deficit.
2. Income. At a higher level of income, we import more. As a result, our supply of dollars on the foreign exchange market increases, creating a balance of payments deficit and downward pressure on the exchange rate. Note that this result assumes that our rise
