Goverment Control

When the foreign exchange needs of a country exceed total receipts from abroad, and it is unable to receive foreign credits, the exchange value of the currency of the country tends to decline. Under these conditions, the government has the alternative of allowing freedom of transactions in foreign exchange and permitting its currency to depreciate, or of abandoning free transfer of currency by the establishment of exchange control. The aim of such control is to limit the demand for and to increase the supply of foreign exchange in order to maintain a stable exchange rate. Control usually provides for allocating foreign exchange only for approved imports and requires that all or part of the foreign exchange derived from exports or other sources be given to the central bank in exchange for local currency. Since the worldwide depression of the early 1930s, many countries, particularly the developing ones with limited exchange reserves, have periodically instituted foreign exchange controls. To help resolve the unbalanced international payments situation after World War II (1939-1945), the United Nations established in 1946 the International Monetary Fund and the International Bank for Reconstruction and Development. The fund promotes currency stability and removal of foreign exchange restrictions by granting member nations foreign exchange loans to cover temporary deficits in their international accounts. The bank grants long-term foreign currency loans to member countries for specific projects.

Price Fluctuation

Foreign exchange is a commodity, and its price fluctuates in accordance with supply and demand; exchange rates are published daily in the principal newspapers of the world and on the World Wide Web. By international agreement fixed exchange rates with a narrow margin of fluctuation existed until 1973, when floating rates were adopted that fluctuate as supply and demand dictate. Foreigners need dollar exchange to pay for goods imported from the United States, for services supplied by Americans, for interest and dividends earned by American capital invested abroad, for the purchase of securities in the United States, and for other types of transactions. Americans buy foreign exchange for similar reasons. Payments for services that must be made by one nation to another include freight charges, insurance premiums, commissions, and travel expenses.

New York City merchants importing goods from the United Kingdom buy drafts on London from their banks. These drafts, or bills of exchange, create a supply of dollars and a demand for pounds. At the same time, other American merchants sell goods to persons in the United Kingdom and receive drafts payable in pounds that they desire to convert into dollars. The foreign exchange banker buys the pounds from the American exporters and sells them to the importers who need pounds in exchange for their dollars.

Ordinarily, and without government restrictions, the rate of exchange, or the price of the currency of one country in terms of that of another, will depend on overall supply and demand and on the relative purchasing power of the two currencies—that is, on the competitive position of the two countries in world markets. At times, speculation in foreign exchange by dealers, brokers, or others becomes a major influence on exchange rates.

Introduction of Foreign Exchange

Foreign Exchange, currency and money claims, such as bank balances and bank drafts, expressed in the equivalent value in foreign money. Thus, a pound sterling note is money in the United Kingdom, but it is foreign exchange in the United States. A deposit of $1,000 in an American bank to the account of a French company constitutes that amount of foreign exchange in France. The term foreign exchange is also used to refer to transactions involving the conversion of money of one country into that of another or to the international transfer of money and credit instruments.

The use of foreign exchange arises because different nations have different monetary units, and the currency of one country cannot be used for making payments in another country. Because of trade, travel, and other transactions between individuals and business enterprises of different countries, it becomes necessary to convert money into the currency of other countries in order to pay for goods or services in those countries. The transfer of money values from one country to another and the determination of the price at which the currency of one country will be surrendered for that of another constitute the main problems of foreign exchange.