12.1.1 Foreign exchange market and nominal exchange rate

The nominal exchange rate is the exchange ratio of two currencies, i.e. the answer to the question: How many US dollars do I get for one Euro? It is formed by supply and demand for the two currencies on the foreign exchange market. Supply and demand are induced by the payment of real flows of goods (estimated share <10%) or by pure investment decisions on the capital market (estimated share >90%). Private actors are mainly influenced by three types of motives:

  1. Real transactions: Terms of Trade
  2. Investment decisions: yield, diversification, interest rates
  3. Speculation: Expected exchange rate changes

The foreign exchange market is a special market. On the one hand, there is a special player, the central bank, and on the other hand, the market is more symmetrical than a normal goods market. Foreign exchange trading is not about a good that a producer produces and a consumer buys for money, so that supply and demand are clearly defined. Rather, it is an exchange in which the demand for one currency is also the supply of the other currency, and vice versa. Every private actor in the foreign exchange market is therefore both supplier and buyer. This makes the situation much more symmetrical than in normal goods markets.

In addition, the central bank appears as a special actor. There is no other market in which an actor holds such an extraordinary position. Firstly, the central bank has very great market power due to its high foreign exchange holdings. It can therefore act both as a buyer of its own currency by selling foreign exchange against its own currency and as a supplier when it sells its own currency against foreign exchange. Secondly, as a seller, it has the special ability to produce the „goods for sale“in almost unlimited quantities at infinitesimal small costs.1 Each central bank can create its own currency by printing the bills fresh or crediting it to the central bank accounts of the banks via computer. Moreover, the central bank is usually the only „producer“of this money. While there are, of course, comparable actors in different markets, e.g. large actors like Blackrock on the capital market (market power) or monopolists (market power, single producer, marginal costs close to zero, e.g. for software), there are only insufficient equivalences for the next two special characteristics of the central bank. Because, thirdly, the central bank can directly influence the incentives for buyers and sellers by changing interest rates or influencing interest rate expectations. While normal companies in markets can only indirectly influence preferences, and thus demand, via marketing, the central bank can (at least in normal times with positive interest rates) influence the demand for its own currency directly, and to a limited extent can even control it. Fourthly, the central bank, if considered as a unit with the government, can legally regulate trade through capital movement controls. That is comparable with Coca Cola being allowed to dictate to all innkeepers that they could no longer sell beer at lunchtime, only water or cola. So far, fortunately, companies can only influence such regulations through lobbying. However, the most effective and efficient method of central banks to control the markets is not actual intervention (1-4), but above all influencing the expectations of market participants so that they behave in such a way that the result desired by the central bank occurs.

1We are talking about monetary costs here, not costs in the sense that an expansive monetary policy fuels inflation and thus can lead to the central bank not – or not so easily – being able to achieve its price stability goal.

(c) by Christian Bauer
Prof. Dr. Christian Bauer
Chair of monetary economics
Trier University
D-54296 Trier
Tel.: +49 (0)651/201-2743
E-mail: Bauer@uni-trier.de
URL: https://www.cbauer.de