Exchange and markets Term Paper Example | Topics and Well Written Essays - 2500 words

Exchange and markets - Term Paper Example It is very difficult to maintain these macro-economic objectives and at times they are even in conflict of each other. (Sloman, 670) Exchange rates fluctuations are a major reason for balance of payment fluctuations. Before we understand the system of exchange rates we need to understand the method of balance of payments. Balance of payments means a record of all transactions made between one particular country and all other countries  during a  specified period of time (www.investopedia.com). BOP  compares the dollar difference of the amount of exports and imports, which includes all financial exports and imports. A negative balance of payments means that more money is flowing out of the country than coming in, and a positive BOP means that more money is coming into the country. Balance of Payment can be said as a huge accounts book for the country. It also acts as an indicator of political and economic stability. A positive BOP may mean that the country’s functioning i s going in a positive direction with foreign investment and funds coming in and limited resources in the form of cash going out. What are nominal exchange rates? Nominal exchange rate is simply the rate at which one currency is exchanged for other. This may mean for example it is quoted that one dollar is equal to 0.6 of a pound sterling. This may mean that the nominal exchange rate of a dollar to the pound is $1= 0.6 pound. Changes in the nominal exchange rates between two countries will have an effect on all the transaction prices of goods bought and sold between those two countries. This means that it is extremely important for these rates to be stables as these are bilateral rates (Bamford et al, 115). In a free market the exchange rate is determined by the market forces of demand and supply. This is quite similar to the determination of all other prices because where the supply and demand curves meet that is the market rate of the currency. For this lets consider the market pri ce of Euros against dollars. The demand for euro will be a downward sloping demand curve. This is because when the price of euro is high in terms of US dollar, then the euro zone goods and services are expensive to US customers. This means that they will have to may more dollars in exchange for euros. This will result in a low demand for euro zone goods and services in the US. Thus few pounds are demanded on the foreign exchange market. As the value of the euro falls against the dollar US customers are able to get more pounds thereby increasing the demand of pounds on the foreign exchange market (Bamford et al, 117). The supply curve of Euro is upward sloping. When the Euro is low against the Dollar, then US goods are expensive in the Euro Zone and as a result less Euros are supplied in the market to buy US goods. On the other hand if the value of the Euro rises then US goods will become cheaper allowing more people in the Euro zone to buy these goods and rising the supply of Euros. Where these demand and supply curves meet the market exchange rate of Euro against Dollar is determined as shorn in the diagram below. ( Diagram taken from Determination of Exchange Rates, http://media.wiley.com/product_data/excerpt/73/EHEP0006/EHEP000673-2.pdf). At all prices above the equilibrium exchange rate the Euros supplied will be greater than the Euros demanded and vice versa. Any changes in the supply or demand of a currency will result in a depreciation or appreciation of the