Economics · Ch 6 — Open Economy Macroeconomics
The Foreign Exchange Market
The Foreign Exchange Market
The Foreign Exchange Market
So far we have looked at the broad accounting of international transactions — the balance of payments as a whole. Now we zoom in on a single transaction to understand how currencies actually get exchanged.
Imagine an Indian resident who wants to visit London on vacation. She is, in economic terms, importing tourist services. To pay for her hotel, meals, and sightseeing in London, she must pay in pounds sterling — the local currency. She cannot pay in rupees; the London hotel will not accept them. So she needs to obtain pounds, and she needs to know at what price she can get them. That price is the exchange rate.
The exchange rate is simply the price of one currency in terms of another. If one pound costs ₹100, the exchange rate is ₹100 per pound. If it costs ₹105, the rate has changed. This price is determined in a market — just like the price of wheat or gold — called the foreign exchange market.
What Is the Foreign Exchange Market?
The foreign exchange market is the market in which national currencies are traded for one another. It is not a single physical building like a stock exchange. Instead, it is a worldwide network of trading centres — in London, New York, Tokyo, Singapore, Mumbai, and elsewhere — that are in close and continuous contact through telephones, computer terminals, and electronic trading platforms. A dealer in Mumbai can buy dollars from a dealer in Singapore within seconds, and the transaction is recorded globally.
The foreign exchange market is the largest financial market in the world by volume. Daily trading turnover runs into trillions of dollars — far exceeding the value of goods and services traded internationally.
Who Participates in the Foreign Exchange Market?
The major participants are:
- Commercial banks — They are the backbone of the market. Banks buy and sell foreign exchange on behalf of their customers (importers, exporters, tourists) and also for their own account to manage their foreign currency holdings.
- Foreign exchange brokers — They act as intermediaries, matching buyers and sellers of currencies. They do not take positions themselves but earn a commission for arranging trades.
- Other authorised dealers — These include financial institutions, investment banks, and large corporations that are permitted to deal in foreign exchange.
- Monetary authorities — Central banks (like the Reserve Bank of India) participate to influence the exchange rate, manage foreign exchange reserves, or implement monetary policy.
Although each participant may have its own trading desk in a specific city, the market itself is worldwide. There is no single location; the market is a global, interconnected web. A participant in one centre can and does deal in multiple markets simultaneously.
The Price: Exchange Rate
The exchange rate is the price at which one currency is exchanged for another. In our example, the Indian resident needs to know the rupee–pound exchange rate. If the rate is ₹100 per pound, she will have to pay ₹100 to get one pound. If she needs £500 for her trip, she will need ₹50,000. …