Foreign exchange markets are where currencies trade, enabling international transactions and investments. They're crucial for global trade, allowing businesses and travelers to exchange money. Understanding these markets is key to grasping how economies interact worldwide.

Exchange rates impact imports, exports, and investments. When a currency strengthens, exports become pricier, while imports get cheaper. This affects trade balances and investment flows, showing how currency values shape economic relationships between countries.

Foreign Exchange Markets and International Capital Flows

Currency Exchange Markets

• Enable transactions between countries using different currencies by allowing importers to exchange domestic currency for foreign currency to buy goods from other countries and exporters to receive foreign currency for goods sold abroad and exchange it for domestic currency
• Facilitate tourism by allowing travelers to obtain the currency of their destination country to make purchases abroad
• Required for international investments as domestic investors exchange currency to make foreign direct investments or buy foreign financial assets and foreign investors exchange their currency for the domestic currency to invest in the local economy

Exchange Rate Changes

• Appreciation (domestic currency becomes stronger relative to foreign currencies) makes exports more expensive for foreign buyers potentially reducing demand, makes imports cheaper for domestic consumers potentially increasing demand, reduces purchasing power of domestic tourists abroad as their currency buys less foreign currency, and increases returns for foreign investors in the domestic economy when they convert profits back to their own currency
• Depreciation (domestic currency becomes weaker relative to foreign currencies) makes exports cheaper for foreign buyers potentially increasing demand, makes imports more expensive for domestic consumers potentially decreasing demand, increases purchasing power of domestic tourists abroad as their currency buys more foreign currency, and decreases returns for foreign investors in the domestic economy when they convert profits back to their own currency

Foreign Investment Types

• Foreign Direct Investment (FDI)
  1. Involves establishing a lasting interest and control in a foreign enterprise
  2. Motivated by long-term strategic goals (accessing new markets, resources, production efficiency)
  3. Implies significant influence and control over the foreign enterprise
  4. Often involves technology and knowledge transfers that can boost productivity in the host country
• Portfolio Investment
  1. Involves buying foreign financial assets (stocks, bonds) without seeking control over the issuing entity
  2. Motivated primarily by short-term financial returns rather than long-term strategic considerations
  3. Does not imply significant influence or control over the foreign enterprise
  4. Can be more volatile as investors may quickly withdraw funds in response to changes in expected returns or risk perceptions
  5. Provides capital for investment in the host country but with less direct impact on productivity compared to FDI