International finance

The foreign exchange market is a market where foreign exchange transactions take place; that is, where different currencies are bought and sold. In practice, this market is not located in any one place, most transactions being conducted by telephone, wire service, or cable.

The three functions of the foreign exchange market are to transfer purchasing power, provide credit, and minimize exchange risk.

The market is dominated by banks; nonbank foreign exchange dealers; individuals and firms conducting commercial and investment transactions; and exchange brokers who buy and sell foreign currencies, making a profit on the difference between the exchange rates and interest rates among the various world financial centers.

In addition to the settlement of obligations incurred through investment, purchases, and other trading, the foreign exchange market involves speculation in exchange futures. New York and London are the major centers for these transactions.

Foreign exchange is an instrument used for international payment. Instruments of foreign currency consist not only of currency, but also of checks, drafts, and bills of exchange.

A foreign exchange market is available for trading foreign currencies.

A foreign exchange rate is the price of one currency in terms of another. For example, one American dollar is 135 yen in Japanese currency.

Fixed exchange rates result from an international financial arrangement in which governments directly intervene in the foreign exchange market to prevent exchange rates from deviating more than a very small margin from some central value.

Flexible rates derive from an arrangement by which exchange rate levels are allowed to change daily in response to market demand and supply. Arrangements may vary from free float, that is, absolutely no government intervention, to managed float, that is, limited but sometimes aggressive government intervention in the foreign exchange market.

The forward rate is the contracted exchange rate for receipt of and payment for foreign currency at a specified date, usually 30 days, 90 days, or 180 days in the future, at a stipulated current or " spot" price.

By buying and selling forward exchange contracts, importers and exporters can protect themselves against the risks of fluctuations in the current exchange market.

There are three forces that will lead to alleviation of a country'» payments imbalance: A rise in the home country's price of imports; a

292

293

fall in the foreign country's price of exports; and a possible rise in interest rates.

In the event of a depreciation of a currency, that currency will, of course, purchase fewer units of foreign currency, and imports will thus become more expensive to domestic consumers. If, for example, the dollar depreciates, the dollar amount of U.S. expenditure on imports will fall if demand is elastic, but will rise if demand is inelastic.

The Marshall-Lerner condition states that depreciation of a currency will result in an excess of exports over imports for the depreciating country if the sum of the elasticities of the home and foreign demands is greater than one. This assumes that supply elasticities are infinite, and that the trade balance was zero before the depreciation.

Since currency depreciation has inflationary effects, the monetary authorities of a country undergoing depreciation may choose to use contractionary monetary policy. If so, there will be a rise in interest rates that will attract a short-term capital inflow. This capital inflow will help to cure the payments imbalance.

Conflicts will occur between external and internal policies in cases where a country has a balance of payments deficit during a period of internal recession.

Contractionary monetary and fiscal policies are appropriate to cure the trade deficit but recession calls for expansionary monetary and fiscal policies.

One way to reduce pressure toward currency depreciation is to restrict imports, as well as to place special taxes on interest or dividends from foreign investment. Such policies tend to disrupt trade and resource allocation and are not widely favored by economists.

Comparing international investments, like comparing apples and oranges, can be a difficult task. Just as an apple and an orange can be priced according to its weight, an international investment can be evaluated according to its total return, the total increase in value plus any dividend or other payments.

College endowment funds, pension fund managers, insurance companies, and individual investors use yields to compare their growing portfolios of global investments. In this way, all investment instruments — ranging from stocks and commodities to art and real estate — can be compared and evaluated by looking at their yield: their percentage increase in value over a given period of time.

Yield, however, is only one factor to consider in evaluating international investments. The final decision has to take into account the risks and tax considerations as well.

Inflation also has to be considered when comparing international investments. Money is worth only what it will buy in goods and services. If prices rise, money loses its value. For example, in order to have the same purchasing power after a decade of inflation, a $ 10, 000 investment in 1980 have had to rise to $ 16, 410 by 1990 just to keep up with the rise in prices.