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Theories

Foreign Exchange Markets

Next theory - Fixed Exchange Rates >>

Each country in the world has its own currency. When individuals or firms import a good or service they need to purchase the currency of the exporting country. Equally exporting firms generally expect to be paid in their own currency. In some cases, often in LDCs, the exporting firms would prefer to be paid in a hard currency i.e. one that is generally acceptable world-wide. However, in most cases importing and exporting can only operate effectively if there is a system whereby countries can exchange currencies. The foreign exchange market enables this to happen. The foreign exchange market is made up of all the institutions that buy and sell foreign currencies. Indeed when you buy foreign currency prior to going on holiday at the bank you are involved in transactions on the foreign exchange market. Your bank must buy the currency of the country you are intending to visit at the relevant exchange rate. A currency's exchange rate represents the value of a country's currency expressed in terms of another country's currency.

When a Zambia farmer wants to purchase a British tractor they must purchase UK pounds on the foreign exchange market. This they must do at the going exchange rate. The problem that Zambia and many LDCs face is that their currencies are weak and not universally acceptable on the foreign exchange market. UK banks will not sell pounds in exchange for Zambian Kwacha as they are not worth a great deal in term of global purchasing power. For Zambia to import tractors it needs to gain access to a hard currency - either pounds or something that can be exchanged for pounds. The importance therefore of its export industries such as copper and agriculture for earning foreign currency is obvious.

The rate at which a country's currency can be exchanged for that of a hard currency is a very important factor when considering the trading position of a country. There are two systems that can determine the value of a country's currency:

• A fixed exchange rate system where a country's government determines the value. This was the system adopted by Zambia until 1991.
• A floating exchange rate regime where the value of the currency is determined by supply and demand for the foreign currency. This system replaced Zambia's fixed exchange rate in 1991.

In addition there are a number of intermediate systems. For example, that operated by the IMF prior to 1971 where the exchange rate of member countries were allowed to float or be market determined between a ceiling and a floor. A similar system existed with the Exchange Rate Mechanism of the European Monetary System.

Next theory - Fixed Exchange Rates >>

Related Glossary Items:
IMF
Exchange Rate Mechanism
Balance of Payments
Fixed Exchange Rate
Floating Exchange Rate

Related Issues:
Zambia's Exports and Imports
Zambia's Trading Partners
The Workings of the IMF

Related Theories:
Floating Exchange Rates
Effects of a Floating Exchange Rate System
The Marshall-Lerner Condition
The Economic Effects of a Devaluation