The international currency market is a market in which participants from around the world buy and sell different currencies. Participants include banks, corporations, central banks, investment management firms, hedge funds, retail forex brokers, and investors. The international currency market is important because it helps to facilitate global transactions, including loans, investments, corporate acquisitions, and global trade.
- How does the International Currency Markets Work?
- What is the Role of Currency?
- What is the Role of Currencies and Exchange Rates to International Trade?
- Why do we Need Currency Exchange Rates?
- What is the Role of Money in International Transaction?
- Why the US Dollar Is the Global Currency?
- How does Currency Help in Economic Activities?
How does the International Currency Markets Work?
The international currency market is the largest financial market in the world, with an average daily trading volume of $5 trillion. In this market, transactions do not occur on a single exchange, but in a global computer network of large banks and brokers from around the world.
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The currency market, or foreign exchange market (“forex”), was created to facilitate the exchange of currency that is necessary as the result of foreign trade. For example, if a Canadian company sells a product to a U.S. firm, it’ll want to be paid in Canadian dollars. The U.S. firm would need to facilitate a foreign exchange conversion through its bank to pay the Canadian company.
The U.S. firm’s bank account would be debited in U.S dollars. The U.S. bank would transfer the funds to the Canadian company’s bank. The funds would be converted to Canadian dollars at a preset exchange rate and credited to the Canadian company’s account.
The global currency market helps to facilitate foreign trade because it allows companies to sell their goods globally and get paid in their local currency. Companies need to be paid in their local currency since their expenses, such as payroll, are in their local currency.
The forex market differs from the stock market in that it does not involve a clearinghouse. Transactions occur directly between parties without an intermediary to ensure that each party complies with its obligations. Currencies do not come with a single price but are priced in terms of other currencies.
What is the Role of Currency?
Money traditionally fulfils three functions:
- a means of exchange, money enables commercial transaction or transactions between individuals to be paid for. It can be exchanged for goods or services. It has an immediate discharging power;
- a unit of account, it enables prices to be established thanks to a recognizable unit accepted by all. It enables the relative value of goods and services to be compared;
- a reserve value, it can be saved and used to keep or transmitted over time.
Whereas the value of money was in the past backed by the value of precious metals, it is today guaranteed by the central banks. It is the trust between citizens and institutions which gives its value to money: we speak of fiduciary money.
The euro has been the only legal tender in France since January 1st, 2002. The Banque de France and the European Central Bank are guarantors of the value of the European currency.
Used every day by nearly 340 million people, the euro facilitates economic movements and exchanges. It has enabled prices and exchange rates to be stabilized, and low interest rates to be guaranteed.
According to mainstream economics, money alleviates this problem. It provides a universal store of value that can be readily used by other members of society. That same baker might need a table instead of shoes. In general, transactions can happen at a much quicker pace because sellers have an easier time finding a buyer with whom they want to do business.
Most importantly, money has to be the unit of account, or numeraire, which is a fancy term for the unit that things are priced in within a society. In the U.S. that is the dollar. Once there is a unit of account, people can indeed exchange on credit without the use of physical money.
Currency is the physical paper notes and coins in circulation. By accepting the currency, a merchant can sell his or her goods and have a convenient way to pay their trading partners. There are other important benefits of currency too. The relatively small size of coins and dollar bills makes them easy to transport. Consider a corn grower who would have to load a cart with food every time he needed to buy something.
Additionally, coins and paper have the advantage of lasting a long time, which is something that can’t be said for all commodities. A farmer who relies on direct trade, for example, may only have a few weeks before his assets spoil. With money, she can accumulate and store her wealth.
What is the Role of Currencies and Exchange Rates to International Trade?
Aside from factors such as interest rates and inflation, the currency exchange rate is one of the most important determinants of a country’s relative level of economic health. Exchange rates play a vital role in a country’s level of trade, which is critical to most every free market economy in the world.
For this reason, exchange rates are among the most watched, analyzed and governmentally manipulated economic measures. But exchange rates matter on a smaller scale as well: they impact the real return of an investor’s portfolio.
Exchange rates are quoted between two currencies. For example – how many Canadian dollars (CAD) can be exchanged for one U.S. dollar (USD)? The exchange rate as of late August 2020 is 1.31, which shows that CAD 1.31 is received if exchanging USD 1.00.
Exchange rates are defined as the price that one nation or economic zone’s currency can be exchanged for another currency. The rates are impacted by two factors:
- The domestic currency value
- The foreign currency value
In addition, the rates can be quoted either directly or indirectly or with the use of cross-rates.
Direct Quotation vs. Indirect Quotation
Direct quotation of exchange rates involves quoting the price of a unit of foreign currency directly in terms of the number of units of domestic currency that are exchanged.
Indirect quotation of exchange rates involves expressing the price of a domestic currency in terms of the number of units of foreign currency that are exchanged.
Cross rates are a method of quoting exchange rates in which various foreign currency exchange rates are used to imply a domestic exchange rate, e.g., if you wanted to determine the EUR/USD exchange rate but can’t access a direct quote. You could use the EUR/CAD exchange rate and the CAD/USD exchange rate to infer the EUR/USD rate.
Why do we Need Currency Exchange Rates?
Exchange rates capture a lot of economic factors and variables and can fluctuate for various reasons. Some of the reasons that exchange rates can fluctuate include:
1. Interest Rates
Changes in interest rates impact currency value and exchange rates. All else being equal, a higher interest rate in a domestic country will increase the demand for a domestic currency since more foreign investors will seek to invest at the higher interest rate, thereby investing foreign capital into the domestic currency. However, in practice, it is balanced out by inflationary pressures.
2. Inflation Rates
Changes in inflation rates impact currency value and exchange rates. All else being equal, a higher inflation rate in a domestic country will decrease the demand for the domestic currency since the value of the currency depreciates relatively faster over time than other foreign currencies.
3. Government Debt
Government debt is the amount of debt owed by a federal government. It impacts currency value and exchange rates since a country with higher debt is less likely to acquire foreign capital, which, in turn, leads to inflation. It puts downward pressure on the domestic currency and decreases its value in exchange rates.
4. Political Stability
The political state of a country influences the currency value and exchange rates since a country with higher political turmoil is less likely to attract foreign investors. Political instability fosters more risk for investors, as they are unsure of whether they will see their investments protected via fair market practices or a strong legal system.
5. Export or Import Activities
A country’s net exports or imports impact currency value and exchange rates. A domestic country that exports more goods than it imports will experience a higher demand for its currency, and thereby, will see its exchange rate increase relative to other foreign currencies.
A country that experiences a recession is less attractive to foreign investors. Firstly, it is due to the increased risk of investing in an economy with a poor economic outlook. Secondly, when a recession occurs, interest rates typically decrease, which decreases the foreign demand for domestic currency.
If a country’s currency is expected to rise for any reason, investors will demand more of the currency to realize a profit based on that expectation. It can cause immediate demand increases for domestic currency relative to foreign currencies.
8. Special Considerations
There are other special considerations when exchange rates are determined. For example, various “safe-haven” currencies are believed to be stable and attract foreign capital when the global economic outlook is uncertain. It includes currencies such as the U.S. dollar, euro, Japanese yen, and Swiss franc.
Another special consideration for the U.S. dollar is that it is the global federal reserve currency, which increases the baseline demand for the U.S. dollar relative to other currencies.
What is the Role of Money in International Transaction?
Money plays a vital role in the economic system of any country. Modern trade transactions whether within the country or at the international level, is based on money. Without foreign currencies, exchange of goods and services across international boundaries would have been impossible. So any resident of a country wanting to purchase goods from abroad must make payment in foreign currency.
Secondly, by serving as a medium of exchange, money facilitates the exchange of good and services among countries in the international market. In international trade, credits are sometimes given and payments are made later. Thus, money enables countries to buy goods on credit in the international market.
Also surplus foreign exchange from international trade is kept as reserves in the form of gold or international currencies such as the dollar. Such surplus enables countries to finance their budget deficits. Without money, the balance of trade and payment accounts cannot be recorded in monetary terms. Money is therefore used to determine the value of exports and imports. This has helped to solve the problem of keeping international transactions in monetary terms.
At the international level, some advanced countries like USA, Germany, use foreign currency to give financial aid to some of the poor countries. This money facilitates economic development by means of foreign capital, thereby helping in the development process of the less developed countries.
Besides, the use of money promotes global trade, which encourages optimal use of the world’s resources.
Why the US Dollar Is the Global Currency?
A global currency is one that is accepted for trade throughout the world. Some of the world’s currencies are accepted for most international transactions. The most popular are the U.S. dollar, the euro, and the yen. Another name for a global currency is the reserve currency.
According to the International Monetary Fund, the U.S. dollar is the most popular. As of the fourth quarter of 2019, it makes up over 60% of all known central bank foreign exchange reserves. That makes it the de facto global currency, even though it doesn’t hold an official title.
The next closest reserve currency is the euro. It makes up 20% of known central bank foreign currency reserves. The chance of the euro becoming a world currency was damaged by the eurozone crisis. It revealed the difficulties of a monetary union that’s guided by separate political entities.
The relative strength of the U.S. economy supports the value of the dollar. It’s the reason the dollar is the most powerful currency. As of the end of 2020, the U.S. had $2.04 trillion in circulation. As much as half that value is estimated to be in circulation abroad.2 Many of these bills are in the former Soviet Union countries and in Latin America. They are often used as hard currency in day-to-day transactions.
In the foreign exchange market, the dollar rules. Around 90% of forex trading involves the U.S. dollar. The dollar is just one of the world’s 185 currencies according to the International Standards Organization List, but most of these currencies are only used inside their own countries.
Almost 40% of the world’s debt is issued in dollars. As a result, foreign banks need a lot of dollars to conduct business. This became evident during the 2008 financial crisis. Non-American banks had $27 trillion in international liabilities denominated in foreign currencies.
Of that, $18 trillion was in U.S. dollars.5 As a result, the U.S. Federal Reserve had to increase its dollar swap line. That was the only way to keep the world’s banks from running out of dollars.
The financial crisis made the dollar even more widely used. In 2018, the banks of Germany, France, and Great Britain held more liabilities denominated in dollars than in their own currencies. Additionally, bank regulations enacted to prevent another crisis can make dollars scarce. that can also happen when the Federal Reserve increases the fed funds rate. That decreases the money supply by making dollars more expensive to borrow.
The dollar’s strength is the reason governments are willing to hold the dollar in their foreign exchange reserves. Governments acquire currencies from their international transactions. They also receive them from domestic businesses and travelers who redeem them for local currencies.
Some governments invest their reserves in foreign currencies. China and Japan deliberately buy the currencies of their main export partners. The United States is the largest export partner to both China and Japan. They try to keep their currencies cheaper in comparison so their exports are competitively priced.
The 1944 Bretton Woods agreement kickstarted the dollar into its current position. Before then, most countries were on the gold standard. Their governments promised to redeem their currencies for their value in gold upon demand.
The world’s developed countries met at Bretton Woods, New Hampshire, to peg the exchange rate for all currencies to the U.S. dollar. At that time, the United States held the largest gold reserves. This agreement allowed other countries to back their currencies with dollars rather than gold.
By the early 1970s, countries began demanding gold for the dollars they held. They needed to combat inflation. Rather than allow Fort Knox to be depleted of all its reserves, President Nixon separated the dollar from gold.
How does Currency Help in Economic Activities?
Economic development is generally believed to be dependent on the growth of real factors such as capital accumulation, technological progress, and increase in quality and skills of labour force. This view does not adequately stress the role of money in the process of economic development.
It is said that money is a mere veil and intrinsically unimportant. What matters is the real goods and productive factors which money buys. However, this extreme view about the unimportance of money as such is no longer believed. Not only is money an important factor without which modern complex economic organization is impossible, but it is also an important factor for promoting economic development.
In the economy today money performs several functions. Money serves as a standard of value in which other values are measured. Money is a store of value, that is, the means in which wealth can be held. It acts as a standard for deferred payments.
However, the most important function of money which distinguishes it from other goods is that it serves as a medium of exchange. That is, money is a means of payment for goods and services. It is this use of money that distinguishes a monetary economy from a barter economy. A monetary economy is one in which goods are sold for money and money is used to buy goods.
Money Promotes Productivity and Economic Growth:
Barter system was full of difficulties of exchanging goods and services between individuals. In the absence of easy exchange of goods and services the barter system worked as an obstacle to the division of labour and specialization among individuals which is an important factor for increasing productivity and economic growth.
Further, the process of economic growth leads to the expansion of production of goods and services and consequential rise in incomes of the people.
As a result, volume of transactions in the developing economy increases. This raises the demand for money to finance the increased transactions brought about by the expanded level of economic activity. Thus, the process of economic growth would be held in check if adequate supply of money is not forthcoming to meet the requirements of increase in the level of economic activity.
Money Promotes Investment:
From the viewpoint of development another important role of money lies in making the magnitude of investment independent of the current level of savings. In a barter system, the goods not consumed constitute the savings as well as investment.
That is, investment is not different from current savings. The greater the current savings, the greater the investment. However, in a modern economy, this is not so. Whereas it is households which save in the form of money, it is the firms which invest money in capital goods.
Therefore, investment can differ from saving because investment activity is separated from the act of saving. More importantly, investment in a monetary economy can exceed the current level of savings. This excess of investment over savings is possible because new money can be created by the Government in the form of currency or by banks in the form of bank deposits. And this is what is important for the purpose of economic development.
In the developed countries in times of depression when idle productive capacity exists, the increase in investment made possible by creation of new money by the Government or banks would lead to the increase in aggregate demand for goods and services.
In such times the supply of goods and services is elastic due to the existence of excess capacity. Therefore, increase in aggregate demand generated by the investment financed by created money brings about expansion in output of goods and services and thereby causes an increase in the level of employment.
In developing countries, the created money can play a useful role in promoting economic development. Rapid economic development can be achieved by stepping up the rate of investment or capital formation. But additional resources are required to increase the rate of investment. But in a country where a majority of the people are living at the bare subsistence level, voluntary savings, taxation.
Government borrowing cannot by themselves provide sufficient investible resources for development. The government therefore attempts to increase the volume of investible resources beyond what is possible on the basis of current level of savings through creating new money. The newly created money can be spent on investment projects both in the industrial and agricultural fields which would lead to the increase in output, income and employment.
Money and Investment in Quick-Yielding Projects:
It is widely believed that any increase in the supply of money in developing countries would lead to the rise in prices or to the emergence of inflationary pressures. However, this is not always true. A reasonable amount of newly created money helps the development of the economy by raising the level of investment. In the developing economies a lot of natural and human resources lie un-utilised and underutilized which can be employed for productive purposes.
If the newly created money is used for investment in those projects such as small irrigation works, land reclamation schemes, flood control and anti-soil erosion measures, cottage industries which yield quick returns, then the danger of inflation will not be there. These quick- yielding projects will increase the production of essential consumer goods in the short run and will therefore prevent the rise in prices.
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Further, if development strategy is such that a higher priority is assigned to agriculture and other wage goods industries and further that organizational and institutional reforms are undertaken to provide all farmers with irrigation facilities, fertilizers and high- yielding varieties, agricultural output can be raised in the short period. In this framework, new money can be created to increase the level of investment without much adverse effect on prices.
Monetization and Economic Growth:
Further, as is well known, most underdeveloped countries have a large non-monetized (i.e. barter) sector where production is for the purpose of subsistence only. To break the subsistence nature of economic activity and thus generate new forces for economic growth, its monetization is required. The introduction of money helps in bringing it in contact with the modern sector. This contact of the subsistence sector with the modern sector will lead to the expansion of its output.
In order to obtain the products of the modern industrial sector, the people engaged in the subsistence sector will make efforts to raise their output. Thus, a surplus of output over their self-consumption will be generated in this way which will ultimately break their subsistence nature.
It is supported by the past history of the developing countries. During the colonial period, the monetization of the peasant sector led to the expansion in exports in exchange for the imported industrial products. This stepped up their agricultural development to a good extent.
Similar to the growth of production for exports the introduction of money in the subsistence agricultural sector and its contact with the modern sector, would lead to the increase in marketable surplus of foodgrains and other agricultural products which is an important factor in economic development.