by A domestic market, also referred to as an internal market or domestic trading, is the supply and demand of goods, services, and securities within a single country. In domestic trading, a firm faces only one set of competitive, economic, and market issues and essentially must deal with only one set of customers, although the company may have several segments in a market.
Most countries have their own currencies, but not all. Sometimes small economies use the currency of an economically larger neighbor. For example, Ecuador, El Salvador, and Panama have decided to dollarize that is, to use the U.S. dollar as their currency. Sometimes nations share a common currency. The best example of a common currency is the Euro, a common currency used by 19 members of the European Union. With these exceptions duly noted, most international transactions require participants to convert from one currency to another when selling, buying, hiring, borrowing, traveling, or investing across national borders. The market in which people or firms use one currency to purchase another currency is called the foreign exchange market.
The term is also used to refer to the customers of a single business who live in the country where the business operates.
There are certain limitations when competing in a domestic market, many of which encourage firms to expand abroad. The main reasons why a business would decide to expand abroad are limited market size and limited growth within the domestic market.
In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer’s margin (or profit) in trading, or else the margin may be recovered in the form of a commission or in some other way.
Different rates may also be quoted for different kinds of exchanges, such as for cash (usually notes only), a documentary form (such as traveller’s checks), or electronic transfers (such as a credit card purchase). There is generally a higher exchange rate on documentary transactions (such as for traveller’s checks) due to the additional time and cost of clearing the document, while cash is available for resale immediately.
Purchasing Power Parity
Purchasing power parity is a way of determining the value of a product after adjusting for price differences and the exchange rate. Indeed, it does not make sense to say that a book costs $20 in the US and £15 in England: the comparison is not equivalent. If we know that the exchange rate is £2/$, the book in England is selling for $30, so the book is actually more expensive in England
If goods can be freely traded across borders with no transportation costs, the Law of One Price posits that exchange rates will adjust until the value of the goods are the same in both countries. Of course, not all products can be traded internationally (e.g. haircuts), and there are transportation costs so the law does not always hold.
The concept of purchasing power parity is important for understanding the two models of equilibrium exchange rates below.
Balance of Payments Model
The balance of payments model holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance. A nation with a trade deficit will experience a reduction in its foreign exchange reserves, which ultimately lowers, or depreciates, the value of its currency. If a currency is undervalued, its nation’s exports become more affordable in the global market while making imports more expensive. After an intermediate period, imports will be forced down and exports will rise, thus stabilizing the trade balance and bringing the currency towards equilibrium.
Asset Market Model
Like purchasing power parity, the balance of payments model focuses largely on tangible goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. The flows from transactions involving financial assets go into the capital account item of the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.
Nominal Exchange Rate
A nominal value is an economic value expressed in monetary terms (that is, in units of a currency). It is not influenced by the change of price or value of the goods and services that currencies can buy. Therefore, changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services that the currency is used to buy.
Real Exchange Rate
The real exchange rate is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio of the number of units of a given country’s currency necessary to buy a market basket of goods in the other country, after acquiring the other country’s currency in the foreign exchange market, to the number of units of the given country’s currency that would be necessary to buy that market basket directly in the given country. The real exchange rate is the nominal rate adjusted for differences in price levels.
A measure of the differences in price levels is Purchasing Power Parity (PPP). The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the purchasing power of the two countries’ currencies. Using the PPP rate for hypothetical currency conversions, a given amount of one currency has the same purchasing power whether used directly to purchase a market basket of goods or used to convert at the PPP rate to the other currency and then purchase the market basket using that currency.
Calculating Exchange Rates
Imagine there are two currencies, A and B. On the open market, 2 A’s can buy one B. The nominal exchange rate would be A/B 2, which means that 2 As would buy a B. This exchange rate can also be expressed as B/A 0.5.
The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries. So, in this example, say it take 10 A’s to buy a specific basket of goods and 15 Bs to buy that same basket. The real exchange rate would be the nominal rate of A/B (2) times the price of the basket of goods in B (15), and divide all that by the price of the basket of goods expressed in A (10). In this case, the real A/B exchange rate is 3.
Demanders and Suppliers of Currency in Foreign Exchange Markets
In foreign exchange markets, demand and supply become closely interrelated, because a person or firm who demands one currency must at the same time supply another currency and vice versa. To get a sense of this, it is useful to consider four groups of people or firms who participate in the market:
(1) Firms that import or export goods and services.
(2) Tourists visiting other countries.
(3) International investors buying ownership (or part-ownership) in a foreign firm.
(4) International investors making financial investments that do not involve ownership. Let’s consider these categories in turn.
Firms that sell exports or buy imports find that their costs for workers, suppliers, and investors are measured in the currency of the nation where their production occurs, but their revenues from sales are measured in the currency of the different nation where their sales happened. So, a Chinese firm exporting abroad will earn some other currency say, U.S. dollars but will need Chinese yuan to pay the workers, suppliers, and investors who are based in China. In the foreign exchange markets, this firm will be a supplier of U.S. dollars and a demander of Chinese yuan.
International tourists need foreign currency for expenses in the country they are visiting; they will supply their home currency to receive the foreign currency. For example, an American tourist who is visiting China will supply U.S. dollars into the foreign exchange market and demand Chinese yuan.
Financial investments that cross international boundaries, and require exchanging currency, are often divided into two categories. Foreign direct investment (FDI) refers to purchasing (at least ten percent) ownership in a firm in another country or starting up a new enterprise in a foreign country. For example, in 2008 the Belgian beer-brewing company InBev bought the U.S. beer-maker Anheuser-Busch for $52 billion. To make this purchase of a U.S. firm, InBev had to supply euros (the currency of Belgium) to the foreign exchange market and demand U.S. dollars.
The other kind of international financial investment, portfolio investment, involves a purely financial investment that does not entail any management responsibility. An example would be a U.S. financial investor who purchased bonds issued by the government of the United Kingdom, or deposited money in a British bank. To make such investments, the American investor would supply U.S. dollars in the foreign exchange market and demand British pounds.
