Mechanics of the Foreign Exchange (FOREX)

• Buying and selling of currency. 
• Any transaction that occurs in the balance of payments necessitates foreign exchange.
• The exchange rate (e) is determined in the foreign currency markets.

 Changes in exchange rates

• Exchange rates (e) are a function of the supply and demand for currency. 
• Increase in the supply of a currency will decrease the exchange rate of a currency. 
• Decrease in supply of a currency will increase the exchange rate of a currency.
• Increase in demand for a currency will increase the exchange rate of a currency.
• Decrease in demand for a currency will decrease the exchange rate of a currency

Appreciation and depreciation

• Appreciation occurs when exchange rate of that currency increases. (e increases)
• Depreciation occurs when exchange rate of that currency decreases (e decreases)
• Determinants of Exchange rate:
• Consumer tastes (buyers taste)
• Relative income
• Relative price level
• Speculation

Exports and imports

• The exchange rate is a determinant of both exports and imports.
• Appreciation of the dollar causes American goods to be relatively more expensive and foreign goods to be relatively cheaper, thus reducing exports and increasing imports.
• Depreciation of the dollar causes American goods to be relatively cheaper and foreign goods to be relatively more expensive, thus increasing exports and reducing imports.
• As two currencies trade:
• One supply line will change; the other demand line will change.
• They will move in the same direction.
• One currency will appreciate, the other will depreciate.
• Flexible rate - Based on the supply and demand of that currency versus the other currency. It is very sensitive to the business cycle and it provides options for investment.
• Fixed rate - Based on country's willingness to distribute currency and to control the amount.