Balancing Supply and Demand of a Country's Currency in the Foreign Exchange Market

and they will buy more Vietnamese goods and assets and thus they will have to convert more foreign currency into Vietnamese Dong to serve this purpose.

7.2.2. Demand for foreign currency

There is a demand for country A's currency in the foreign exchange market when people from other countries buy goods and services produced in country A. The firms and workers who produce the goods must be paid in country A's currency, which requires foreign buyers to buy the currency in the foreign exchange market. The more a country exports, the greater the demand for its currency in the foreign exchange market.

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The demand curve for a currency as a function of its exchange rate (the quantity of other currencies for which it can be exchanged, or the “price” of the currency in the foreign exchange market) slopes downward to the right; the higher the exchange rate, the more expensive the country's goods become to foreigners and fewer goods are exported.

International means of payment for reserve money: especially for some countries with “strong” currencies, it is necessary to use for transactions as reserve money at banks in other countries. Specifically: US dollar, German mark, Japanese yen, Swiss franc and British pound.

These demands push the demand for these currencies above and beyond what would arise from the countries' own trade activities, in their foreign exchange markets.

For example: The demand for US dollars in the exchange market between Vietnamese Dong and US dollars simply comes from international transactions in the opposite direction compared to the supply of US dollars. So who has the demand for US dollars? Vietnamese citizens and companies that need to buy foreign goods or assets will have to supply Vietnamese Dong to convert to US dollars.

The demand curve for US dollars is downward sloping because when the US dollar appreciates against the Vietnamese dong, foreign goods and assets become more expensive and less attractive to Vietnamese people. We will buy fewer foreign goods and assets and therefore will need less US dollars.

7.2.3. Balancing the supply and demand of a country's foreign currency in the foreign exchange market

Exchange rates are determined primarily by the supply and demand for currencies in the foreign exchange market. Anything that increases the demand for a currency in the foreign exchange markets or reduces its supply tends to cause the exchange rate to rise, and vice versa.

E USD/VND

E 2 E 0 E 1

S USD

D USD

Q USD

Figure 7.1: Foreign exchange market of VND against USD

7.2.4. Causes of shifts in the supply and demand curves for money in the foreign exchange market.

There are many reasons for the shift in the supply and demand curve of currencies in the foreign exchange market. The main reasons are:

+ Trade balance: In other conditions remaining constant, if a country's imports increase, the country's money supply curve will shift to the right.

+ Relative inflation rate: If a country's inflation rate is higher than another country's inflation rate, that country will need more money to buy a certain amount of the other country's money. This causes the money supply curve to shift to the right and the exchange rate to fall.

+ Foreign currency reserves and investments: Speculation can cause large changes in money, especially in conditions of modern communication and modern computer technology that can exchange currency values every day.

+ Capital movement: When foreigners buy financial assets, interest rates have a strong influence. When a country's interest rate increases relative to another country, its assets generate a higher rate of return and more foreigners want to buy those assets. This shifts the demand curve for that country's money to the right and increases its exchange rate. This is one of the most important influences on exchange rates in highly developed countries.

Above are the four basic causes of shifts in supply and demand curves in the foreign exchange market. These shifts in turn cause fluctuations in exchange rates. And as a chain reaction, fluctuations in exchange rates impact the domestic economy.

7.2.5. Exchange rate

The exchange rate is the price of one country's currency in terms of another country's currency.

For example: A Vietnamese citizen buys 1 kg of coffee in Vietnam, of course he wants to pay in Vietnamese Dong. Coffee producers also want to be paid in Vietnamese Dong because their daily expenses are also paid in VND. However, if they want to buy an American photocopier, somehow they still have to pay in USD to the Americans. Conversely, if an American wants to buy coffee from Vietnam, somehow they still have to pay in VND. Trading between two countries using two different currencies requires converting one currency to another. From there, the exchange rate is formed.

Normally, the term “exchange rate” is understood as the number of domestic currency units needed to buy one foreign currency unit. In the US and UK, however, the term is used in the opposite sense: the number of foreign currency units needed to buy one US dollar or British pound.

For example, the exchange rate for the French franc is published in France as 2FF/DM, while the same rate in Germany is 0.33 DM/FF. The exchange rate for the British pound is usually published as, for example, 1.25 USD/Pound, or for the US dollar: 250 Yen/USD.

In Vietnam, the Vietnamese Dong exchange rate announced by the Foreign Trade Bank is according to international practice: the number of Vietnamese Dong units needed to buy one foreign currency unit, for example 21,135 VND/USD.

We denote the exchange rate as E. In the above situation we would write as follows: E VND/USD = 21,135.

7.2.5.1. Nominal exchange rate and real exchange rate

- Nominal exchange rate: is the relative price of the currencies of two countries. Normally, the exchange rate is understood as the amount of domestic currency needed to exchange for one unit of foreign currency (denoted as E), and sometimes it is understood as the amount of foreign currency needed to exchange for one unit of domestic currency (denoted as e).

For example, when you go to the bank, you see that they list 95 yen per USD. If you give the bank one USD, they will give you back 95 Japanese yen; and if you give the bank 95 yen, they will give you back 1 USD. In reality, the bank lists different prices for selling and buying yen. This difference is one of the sources of the bank's profit for providing this service. To simplify the problem, we will ignore this difference.

Exchange rates can be expressed in two forms. If the exchange rate is 95

If one yen is worth one dollar, it is also 1/95 (=0.0105) of a dollar.

If the exchange rate changes so that one dollar can buy more foreign currency, we say that the dollar has appreciated. If the exchange rate changes so that one dollar can buy less foreign currency, we say that the dollar has depreciated.

You may have seen the media talk about the US dollar being strong or weak. These terms are often used to refer to changes in nominal exchange rates. When a currency appreciates, it is said to be stronger because it can buy more foreign currency. Conversely, when a currency depreciates, it is said to be weaker.

For any country, we find many nominal exchange rates. US dollars can be used to buy Vietnamese dong, Japanese yen, British pounds, Mexican pesos, and so on. When studying changes in exchange rates, economists often use indexes that are calculated as averages of many exchange rates. Just as a retail price index converts many prices in the economy into a single quantity to reflect the price level, an exchange rate index converts different exchange rates into a single quantity to reflect the international value of money. So when economists say the US dollar is appreciating or depreciating, they usually mean an exchange rate index that takes into account many individual exchange rates.

- Real exchange rate: is the rate at which a person exchanges the goods and services of one country for the goods and services of another country. In other words, the real exchange rate is the relative price of goods in two countries.

For example, when you shop, you find that a case of German beer costs twice as much as a case of American beer. We can say that the real exchange rate is 1/2 case of German beer costs 1 case of American beer. Note that, like the nominal exchange rate, we express the real exchange rate as the number of units of foreign goods per unit of domestic goods.

Why is the real exchange rate important? As you might have guessed, the real exchange rate is a key factor in determining how much a country will import and export. For example, when Truong An Company decides to buy rice from the US or Japan for its stockpile, it is concerned with which country's rice is cheaper. The real exchange rate answers this concern. Another example is when you have to decide whether to go on vacation to Phuket, Thailand, or to Bali, Indonesia. You ask the price of a hotel in Phuket (in baht) and the price of a hotel in Bali (in rupees) and the exchange rate between baht and rupees. If you want to decide where to go on vacation by comparing costs, then you are making a decision based on the real exchange rate.

When studying the economy as a whole, macroeconomics is concerned with the general price level, not the unit prices of individual goods. That is, to calculate the real exchange rate, one uses a price index, such as the consumer price index, a

index that shows the price of a basket of goods and services.

This real exchange rate represents the price of a basket of domestically produced goods and services relative to a basket of foreign goods and services. A country's real exchange rate is a key determinant of its net exports of goods and services.

7.2.5.2. Relationship between nominal exchange rate and real exchange rate

Nominal and real exchange rates are closely related. To understand why, consider the following example. Suppose a bushel of American rice sells for $100, and a bushel of Japanese rice sells for 19,000 yen. What is the real exchange rate between American rice and Japanese rice? To answer this question, we first use the nominal exchange rate to convert prices into the same currency. If the nominal exchange rate is 95 yen per dollar and the price of American rice is $100 per bushel, then the price of American rice would be 9,500 yen per bushel. American rice is half as cheap as Japanese rice. The real exchange rate is 1/2 bushel of Japanese rice per bushel of American rice.

Real exchange rate = Nominal exchange rate x (Foreign price/Domestic price)

From the above formula we see: the real exchange rate depends on the nominal exchange rate and the price of goods of the two countries in their domestic currencies.

In there:

ε = E x (P * /P) (7.2)

ε is the real exchange rate

E is the nominal exchange rate P is the domestic price of goods P * is the foreign price

Thus: If a country's real exchange rate falls, it means that its goods become cheaper relative to those of other countries. This change encourages both domestic and foreign consumers to buy more of that country's goods. As a result, the country's exports increase and its imports decrease. Both factors cause net exports to increase. Conversely, an appreciation of a country's currency in its real exchange rate means that its goods become more expensive relative to those of other countries and net exports will decrease.

Below, let's look at how exchange rates are determined in the forex market.

7.2.5.3. Determining exchange rates in a floating exchange rate system

In this section we consider a system in which the exchange rate is determined entirely by supply and demand in a competitive free market and without any central bank intervention.

Like any competitive price, the exchange rate will fluctuate according to the conditions of demand and supply. Suppose the current price of USD is too low (for example, E 1 in Figure 7.1). Then the quantity demanded of USD exceeds the quantity supplied. Because USD is scarce, some companies that need USD to pay for import contracts cannot buy USD and will be willing to pay a higher price to buy the necessary amount of USD. Such actions will push the price of USD up to E 0 . Conversely, if the current price of USD is too high, say E 2 , then the quantity of USD demanded is lower than the quantity of USD supplied. Many people who need to sell USD will not be able to sell and will be willing to lower the price to sell the necessary amount of USD. Only at the exchange rate E 0 will the adjustment process stop. At that point, the quantity demanded of USD is exactly equal to the quantity of USD supplied. E 0 is called the equilibrium exchange rate.

* Exchange rate changes

What causes exchange rates to fluctuate? The simplest answer is due to changes in supply and demand in the foreign exchange market. Anything that shifts the demand curve for US dollars to the right or the supply curve for US dollars to the left will cause the US dollar to appreciate against the Vietnamese dong. Conversely, anything that shifts the demand curve for US dollars to the left or the supply curve for US dollars to the right will cause the US dollar to depreciate against the Vietnamese dong. This is simply the application of the law of supply and demand to the foreign exchange market.

So, what shifts the demand curve for US dollars and the supply curve for US dollars in the foreign exchange market and causes the exchange rate to fluctuate? There are actually many different reasons. Below we will discuss some of the most important reasons:

- Increase in domestic prices of exported goods

Suppose the price of Vietnamese seafood increases in VND. What happens to the supply of US dollars depends on the price elasticity of American demand for Vietnamese seafood.

If demand is very elastic, perhaps because many other countries sell similar products in the US market, then Americans will spend less money on Vietnamese seafood and therefore there will be less US dollars available to convert into Vietnamese dong. On the graph, the supply curve for US dollars shifts to the left and the US dollar will appreciate against the dong. This is shown in panel b of Figure 7.2.

If demand is inelastic, then Americans will actually have to spend more dollars to buy Vietnamese seafood. In panel b of Figure 7.2, the supply curve for US dollars will shift to the right from S 0 to S 1 and the US dollar will depreciate against the Vietnamese dong from E 0 to E 1 .

E VND/USD

E 2 E 0

E VND/USD

S 0

D 1 E 0

E 1

D 0

S 0

B S 1

D 0

Q 0 Q 1

Q USD

Q 0 Q 1

Q USD

a. Shift in demand curve b. Shift in supply curve Figure 7.2: Change in exchange rate

- The increase in international prices of imported goods

Suppose that the dollar price of US-made electronics increases significantly. Suppose also that Vietnamese consumers have a highly price-elastic demand for US electronics. Therefore, we will need fewer US dollars than before to buy US electronics. The demand curve for US dollars shifts to the left and the US dollar depreciates against the Vietnamese dong. This is illustrated in panel a of Figure 7.2. The opposite occurs if the demand for US electronics is inelastic.

- Changes in general price levels

Instead of the price of one export changing, we now assume that the price of all goods changes due to inflation in the economy. Then the general price of Vietnamese goods will change relative to the general price of its trading partners. In the simple model with only two countries, the US acts as the rest of the world.

If the price level in both countries increases by the same percentage, say 10%. Then the price in US dollars and the price in Vietnamese dong of Vietnamese goods both increase by 10%. At the current exchange rate, the price in Vietnamese dong of US goods and the price in USD of Vietnamese goods both increase by 10%. Therefore, the relative price of imported goods and domestically produced goods will not change in both countries. Therefore, the same inflation in both countries will not affect the equilibrium exchange rate.

However, what happens if Vietnam experiences inflation while prices remain stable in the United States? The dong prices of Vietnamese goods will rise and they will become more expensive in the United States. This will reduce the quantity of Vietnamese goods exported to the United States and reduce the amount of dong that U.S. importers demand. At the same time, U.S. exports to Vietnam will have unchanged dong prices while the prices of Vietnamese goods sold domestically will increase due to inflation. Thus, U.S. goods will become more attractive relative to Vietnamese goods because they become relatively cheaper, and Vietnamese people will be willing to buy more U.S. goods. At each exchange rate, the demand for U.S. dollars increases.

Thus, on the graph, the supply curve for US dollars shifts to the left while the demand curve for US dollars shifts to the right. As a result, the price of the US dollar in equilibrium will increase: the Vietnamese dong will lose value compared to the US dollar.

- Speculation

An important factor determining exchange rates is speculation. The demand for an asset depends on the expected price at which it can be sold in the future. Money in any country is an asset. If Vietnamese people believe that the US dollar will appreciate relative to the Vietnamese dong in the future, they may want to hold more US dollars now. This shifts the demand curve for US dollars to the right. As a result, the US dollar appreciates relative to the Vietnamese dong. The reverse is true.

7.2.6. Exchange rate system

There are many systems that have been used to establish exchange rates such as: Fixed exchange rate systems, floating exchange rate systems and managed floating rates.

7.2.6.1. Fixed exchange rate system: Bretton Woods (1944-1971)

Near the end of World War II a multinational conference was held in Bretton Woods New Hampshire (USA) to plan “an orderly system of exchange rates favorable to the free flow of trade”.

The system has the following elements:

- The price of gold is fixed at 35 USD per Ounce. This means that the value of the US dollar is fixed to gold.

- The currencies of the countries participating in the system are fixed to the US dollar, the central banks of these countries are responsible for maintaining their exchange rates by buying and selling USD in the foreign exchange market.

- The International Monetary Fund (IMF) was formed to manage this system and perform some of the functions of an international central bank.

The functions of the IMF in this system are: to ensure that countries maintain