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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New demand = old demand + amount withdrawn New supply = old supply - inflow that stopped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Amount withdrawn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 2 of 22
The real wordsTheory

The definition

Foreign exchange marketthe market where individuals, firms and banks buy and sell foreign currencies or foreign exchange.

The slide adds one crucial clause: the participants are connected electronically, forming a single international foreign exchange market.

That is why arbitrage works, and why the rupee-dollar rate in Mumbai cannot drift away from the rate in Singapore. In the professors' Indian framing the same market is described as the global marketplace for buying and selling national currencies, with commercial banks, brokers, the RBI and corporates as participants.

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