Foreign Exchange Essay

Foreign Exchange

I.                   Introduction

International trade has become a natural part of business today. Businessman, companies and countries cannot survive economically without the help of parties outside national boundaries. In light of this condition, the role of international cooperation, especially in terms of economic, has become very important. In this paper, we are discussing the foreign exchange market as a tool that facilitates international trade.

II.                Foreign Exchange Markets and Their Roles

Foreign exchange (forex) market is by far the largest market in the world in terms of economic circulation. The average value of transactions in the forex market already exceeds US $ 1.9 trillion/day today. The number is predicted to grow continuously. It involves transaction between large banks, governments, multinational corporations, financial institutions, central banks and even individual currency speculators (Millman, 1995).

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  The foreign exchange market is simply a market exists wherever a currency is traded for another. Therefore, it has no single exchange center that acts as a clearing house. The international forex transactions however, are quite concentrated in nature. 73% of the global forex transactions occur in only 10 of the most active nations in forex trade. The largest geographic trading center is in United Kingdom. The United Kingdom has a global share of forex transactions that exceeds 30% in 2006. Other large geographic center of forex transaction is in the United States, where more than 18% of global share of forex transactions occurs. Next is Japan, with more than 7% of the global forex. Transactions, and Singapore, with about 6% share of the global forex transactions (Millman, 1995).

Generally, the role of the world’s major forex markets as mentioned above is no other than to accommodate and determine exchange rate. In those forex markets, exchange rate is determined through basic principles of supply and demands, or in other words, exports and imports. The markets create the principal rate–setting mechanism in currency exchanges. In other words, the act as a facilitator which allows and protects the system where supply and demands dictates the value of currencies.

Besides this principle role however, the foreign exchange markets also have other functions. They act as a medium of investment, whether they are in the form of speculation of hedging and they also act as an efficient channel to obtain or disposing foreign currencies. Because of these roles, most of the world currencies are affected by the forex market.

There are various factors that affected the forex markets and how it determines the value of all currencies involved. Some of those factors are:

·         Economic factors

In the forex markets, currencies are influenced by economic policies and economic conditions. Economic policies include fiscal policies and monetary policies. Governments can attempt to influence the value of their currencies by changing their budgetary practices or by changing the supply and ‘cost’ of money. Economic conditions on the other hand, includes: government budget deficits or surpluses, trends and balance of trade levels, inflation levels, economic growth. For example, a nation looses the value of its currency whenever there is a high level of inflation that diminishes purchasing capability of the society. Other example, if a country has a healthy and robust economic growth, there will be more people demanding its currency in order to do business with the country (Cohen, 1990).

·         Political Factors

It has been notice that political conditions and events have profound effects on currency markets. In developing countries and some of the developed ones, the change of political leadership or transformation in political structure may spur positive or negative interests inside or outside the country, and thus affect the country’s currency (Cohen, 1990).

·         Market Psychology

Besides economic and political factors, currency values in international markets are also affected by market psychology and perceptions among traders and influential people of the markets. The factor is less ‘vivid’ than economic or political factors. However, learning about this factor can help international managers and business owners to better understand the behavior of currencies in forex markets (Cohen, 1990).

III.             The Gold Standard

The forex markets become highly popular and highly influential in the modern business world because most countries are now using fiat money as the basis of their foreign trade activities. The fiat money system however, is not always the most influential system in international trade. There are times where the most popular trade system between countries is not the fiat system, but rather the gold standard system, the Bretton Woods system, etc. In this chapter, we will discuss the gold standard system as an alternative to the fiat money system.

III.1.   Positive Traits of the Gold Standard

The gold standard was once a popular idea in international markets. It was used in the beginning of the 20th century to adjust monetary supply. The system is based on the notion that all currencies are tied to a specific amount of gold. Many believed that this logic is a good and powerful one. Without the presence of a tangible and precious item, currency is just paper bills and nothing more. Tying paper money to an amount of gold gives the holder of the paper money the right to obtain real gold in the basis of the intrinsic value of the paper money (Pollard, 1990).

In this arrangement, all national bank must have some amount of gold reserve to ensure its capability to provide paper money for its economy. A central bank cannot print paper money when it has no gold reserves. There are worries that a powerful country would not let go of gold reserves and leave other economies weak. In theory however, this is not possible because of the mechanism. In theory, all countries will be led to balance of payments as a final destination of the economic process (Pollard, 1990).

 For example, if nation A has a foreign trade deficit toward nation B, then nation A will be sending a determined amount of gold to nation B, leaving nation B with the opportunity to print more money to accelerate economic growth. This would induce enhanced inflation. In time, prices in nation B would be higher which reduce international interest in buying goods from nation B. As a result, nation B will have a deficit of trade toward other countries and force the country to reduce its gold reserves. In theory, the gold standard will lead to balance of payments, where all countries will have no surplus or deficit.

III.2.   Negative Traits of the Gold Standard

            In reality however, the gold standard faces many problems. For one, the balancing effects that should take place when gold left a nation seldom take place immediately. Nations which have the opportunity to enhance economic growth often neglected the chance, and instead, causing recessions and unemployment. Furthermore, it has been discovered that there is a huge safety issue when the gold standard is used. The delicate balance of the gold standard, which relies upon the safe delivery of gold from one nation to the other, is often obstructed by criminal actions. They destroy the theoretical balance of payment that has been mentioned previously.

            Experts and observers have also stated that the gold standard displayed a lack of flexibility in providing economic support or growth. In the end, people would prefer a flexible system that allows the production of money as an instrument of economic growth whenever the risk is acceptable. Observers also believed that the balance of payment feature in the gold standard can be better performed through government intervention and exchange of reserve currencies (Abdul-Monem, 2007).

Bibliography

Abdel-Monem, Tarik. 2007. ‘What is the Gold Standard?’. Retrieved May 22, 2007 from

Cohen, Benjamin J. 1997. ‘International Trade and Finance: New Frontiers for Research’. New York: Cambridge University Press.

Pollard, Sydney. 1970. ‘Gold Standard and Employment Policies between the Wars’

Millman, Gregory J. 1995. ‘Around the World on a Trillion Dollars a Day’. Bantam Press, New York.