An Example o f Determining Foreign Exchange Rates in a Market

When you decide to buy foreign products, such as Scotch whisky, you have dollars to pay the

Scottish alcohol drink maker. The Scottish alcohol drink maker, however, cannot pay workers in

Dollars. The workers are the Scotch, they live in Scotland, and they need sterlings to buy goods and

Services in that country. There must be, therefore, some way of exchanging dollars for sterlings that

The alcohol drink maker will accept. That exchange occurs in a foreign exchange market, which in

This case specializes in exchanging sterlings and dollars. (When you obtain foreign currencies at a

Bank or an airport currency exchange, you are participating in the foreign exchange market.)

The particular exchange rate between sterlings and dollars that would prevail depends on the current

Demand for and supply of sterlings and dollars. In a sense, then, our analysis of the exchange rate between

Dollars and sterlings will be familiar to us, for we have already used the supply and demand terminology. If

it costs you $1,5 to buy ￡1, this is the foreign exchange rate determined by the current demand for and

Supply of sterlings in the foreign exchange market. The Scotsman going to the foreign exchange market