Foreign exchange markets enable international trade to take place by providing markets for the exchange of national currencies. A U.S. firm which sells goods to a British firm needs to exchange the check (in pounds) sent by the British company into dollars. U.S. exports create a demand for dollars and a supply of foreign money, pounds in this case. On the other hand, imports create a supply for dollars and a demand of foreign money.
Variable Exchange Rate
The freely floating exchange rates are determined by the forces of demand and supply. The intersection of supply and demand curves for a currency will determine the price or exchange rate. Theoretically, variable rates have the virtue of automatically correcting any imbalance in the balance of payments. Balance of payments is the sum of all transactions, which take place between a nationís residents and the residents of all foreign nations. If there is a deficit in the balance of payments, this means that there will be a surplus of that currency and its value will depreciate. As depreciation occurs, prices for goods and services from that country become more attractive and the demand for them will rise. At the same time, imports become more costly as it takes more currency to buy foreign goods and services. With rising exports and falling imports, the deficit is eventually corrected. In addition, flexible exchange rates allow policy makers to be flexible in conducting domestic monetary and fiscal policies. However, unstable exchange rates can destabilize a nationís economy. This is especially true for nations whose exports and imports are a substantial part of their GDPs.
Fixed Exchange Rate
If the government offers to buy and sell its currencies at a set price, it is imposing a fixed exchange rate. A nationís reserves are used to alleviate imbalance in the balance of payments, since exchange rates cannot fluctuate to bring about automatic balance. Domestic macroeconomic adjustments may be more difficult under fixed rates. For example, a persistent deficit of trade may call for tight monetary and fiscal policies to reduce price, which raises exports and reduces imports. However, such contractionary policies can also cause recessions and unemployment.
Managed Floating Exchange Rate
The current system is a managed floating exchange rate system in which governments attempt to prevent rates from changing too rapidly in the short term. Since 1987, the G-7 nations ( U.S., Germany, Japan, Britain, France, Italy and Canada) have periodically intervened in foreign exchange markets to stabilize currency values.