Skip to content
Sem 5 Prep
← Open Economy MacroWhat the foreign exchange market does

Formulas for this chapter

Market imbalance and the reserve consequence

Excess demand = total demand - total supply Fixed rate: reserve change = -(excess demand) Flexible rate: reserve change = 0, the currency depreciates

Any question that lists foreign exchange flows and asks what happens next. Sort every item into demand or supply first; the arithmetic is trivial once the sorting is right.

Demand
Import payments, investment abroad, outbound tourism, capital withdrawals: money leaving
Supply
Export receipts, inbound remittances, foreign investment received: money arriving
Excess demand
A BoP deficit on those flows, settled by reserves or by a price change

Effect of a capital reversal

New demand = old demand + amount withdrawn New supply = old supply - inflow that stopped

When portfolio investors reverse course. A withdrawal is not negative supply, so both sides of the market move and the pressure exceeds the size of the reversal.

Amount withdrawn
Repatriated capital, which must be converted out of the domestic currency, so it is fresh demand
Inflow that stopped
The investment that is no longer arriving, so it leaves the supply side
Step 1 of 22
The ideaTheory

A shop that never closes

Think of a currency exchange counter at an airport, then imagine every such counter in the world wired to every other one, quoting the same price at the same instant.

That is the foreign exchange market: not a building, a network.

Its job sounds dull and is not. Somebody in Kochi sold software to Ohio and holds dollars they cannot spend at home. Somebody in Kochi is flying to Ohio and needs dollars they do not have. The market's first function is simply to put those two people together.

← BackContinue →