Currency markets and their effects on the U.S. economy Essay

Currency markets and their effects on the U.S. economy - Essay Example This paper discusses currency markets, how they operate, and how they affect the economy of the United States. The specific cases of two foreign currencies - the Euro and the Japanese Yen - and the impact of their movements on the U.S. economy are analyzed to provide a clearer picture that would facilitate the understanding of the theory.Although the term "currency" is synonymous with "money" that is a medium of economic exchange, what would be discussed in this paper is the currency market, not the money market. The reasons for this distinction will be explained below.A currency market, like any other market, is a place where currencies are bought and sold. This is different from a money market, which is where monetary or financial instruments such as bonds, stocks, derivatives, insurance policies, mutual funds and similar goods are transacted. However, currency and money markets share four key elements that allow transactions in any market to take place.First, the market should exi st either physically in a building as the New York Stock Exchange, the Chicago Mercantile Exchange for commodities, or a neighborhood flea market, or virtually in a computer system which is the case for most markets where bonds, derivatives, or currencies are bought and sold. In the currency market, there is no single location where currencies are traded. Instead, there are many trades taking place, in banks, moneychangers, shops, even hotels, and each venue has a set of exchange rates for "buy" and "sell" bids, with the latter usually higher by a fraction. These rates are the prices that the agent is willing to pay for (buy) or get paid for (sell) in transacting each currency. Then, there should be goods that are exchanged in this market; buyers and sellers who either buy or sell the goods; and money that is used as the medium of exchange. A market transaction is therefore where buyers acquire from sellers certain goods in exchange for money at an agreed price. The main difference between all the other types of markets such as money markets and a currency market is that in a currency market, the goods bought and sold are currencies and the payments are also made in currencies that are denominated differently from that which is sold or bought. Therefore, in a currency market, someone or an entity that wants to buy U.S. dollars can buy it using Euros (denomination of the Eurozone currency), Yen (Japan), Pounds Sterling (United Kingdom), and so on. This brings an important question to mind: how much is a U.S. dollar worth, and if what it is worth determines the price that others are going to pay for it, why is the currency of the U.S. not the same as the currency of other countries What determines the price of currencies in the market The answers to these questions depend on an understanding of what is called the monetary system, or the way the money supply is determined in each country and, therefore, in the whole world. Knowing how the monetary system operates will give a better understanding of how currency prices are determined in the currency market. Monetary System A clear understanding of the world's monetary system will explain how a currency is valued, how its value compares with other currencies defined by the exchange rate, the roles that exchange rates play in the world economy, and how exchange rates are determined. Solomon (in Samuelson and Nordhaus) described the monetary system as follows: 'The world's monetary system is like the traffic lights in a city, taken for granted until it begins to malfunction and to disrupt people's livesA well-functioning monetary system will facilitate international trade and investment and smooth adaptation to change. A monetary system that functions poorly may not only discourage the development of trade and investment among nations but subject their economies to disruptive shocks when necessary adjustments are prevented or delayed" (1, 7)