What are the effects of the global economy as far as foreign exchange markets?
Globalization, which is the liberalization or opening of markets to the world, has influenced and reshaped economic and financial areas. One such area is foreign exchange markets. Increased trade led to the growth in foreign assets and shift in liability positions as determined by growth in gross domestic product or dynamics of financial variables. The global market has also dispersed the position of economies in terms of net foreign assets expressed through economies primarily holding the creditor or debtor position.
Globalization has built momentum for spillovers of asset prices and foreign currency movements with the rise in the volume of net capital flows in the global market. (Lane & Milesi-Ferretti, 2005) This means that the global market affects the foreign exchange markets by influencing the net foreign asset position of economies through the foreign asset flows into and out of economies that in turn influence the value of currencies in the foreign exchange market.
There are two perspectives on the manner that the global market affects the net foreign asset position of foreign exchange markets. On one hand, the traditional perspective explains that net foreign asset position has close links with the trade balance (Lane & Milesi-Ferretti, 2005). This means that exchange rates influence the movement of net foreign asset position as it affects the trade balance. In case of greater volume of export products, price becomes cheaper in the global market relative to imports becoming more expensive in the global and domestic market.
This affects the trade balance through the improvement in export returns leading to a trade balance that causes improvements in net foreign asset position. Concurrently, lower level of exports causes an increase in price in the global market and relative lower price for import products. This leads to lesser export returns and the trade balance, which in turn affect the foreign exchange market. The extent that the trade balance plays out determines the net foreign asset position of currencies.
Movements in the trade balance, as influenced by shifts in the global market, affect the net foreign asset position of currencies, including the domestic currency, in the foreign exchange market. As such, the foreign exchange market works much like trade but only in foreign currencies instead of commodities, so that the trade-balance effect also occurs in the foreign exchange market. The connection of a foreign exchange market with the global economy through the trade balance is also affected by fiscal trade-related policies that affect the volume of exports and imports (Taylor & Sarno, 2001).
This means that the effect of shifts in the global economy could be tempered in part due to the fiscal and monetary policies implemented in the economy, although, policies could also be influenced by pressures from the global economy. On the other hand, the contemporary perspective recognizes that the global economy not only affects the foreign currency market via shifts in the trade balance that translates into the foreign currency market but also the shifts in the relative value of currencies in the form of depreciation and appreciation that in turn affects relative net foreign asset position (Lane & Milesi-Ferretti, 2005).
In the balance of trade, the volume of export returns influence net foreign asset position by causing an appreciation or depreciation of the domestic currency brought about by the entry of greater volumes of foreign currency, especially the US dollar on which many currencies are pegged (Lane & Milesi-Ferretti, 2005). In the case of depreciation, the weakens the net foreign asset position of the domestic currency while in appreciation this improves the net foreign asset position of the domestic currency in the domestic foreign exchange market.
Apart from the effect of the global economy on foreign exchange markets through the relative value of the domestic currency that in turn influence the net foreign asset position of currency, there are also factors that influence the price such as gross domestic product and monetary policy. These factors could be influenced directly or indirectly by the global economy.
Gross domestic product affects the net foreign asset position of domestic currencies depending on the extent of product market integration or globalization in real terms, affected by policy (Taylor & Sarno, 2001), that in turn influence exchange rate adjustment and the value of domestic currency in the foreign exchange market (Lane & Milesi-Ferretti, 2005). The extent of exchange rate adjustment depends on the substitution effect of foreign products.
In case of greater substitutability, exchange rate adjustments occur easily. In the case of foreign exchange trading, a more common occurrence is diversified international portfolios that lead to trade imbalance. The extent of imbalance and foreign currency adjustment determine changes in net foreign asset position. Monetary policy intervenes in the foreign exchange market depending on whether the policy leans towards fixed or floating exchange rates.
A pegged currency to the US dollar means that the value of the domestic currency weakens as the value of the US dollar appreciates. A floating exchange rate determines the value of currency based on other foreign exchange market factors. (Taylor & Sarno, 2001) A pegged or floating currency policy is influenced in part by the global economy through the position of the US economy and the rise of the US dollar as the international currency.
Reference List
Lane, P. R., & Milesi-Ferretti, G. M. (2005). Financial globalization and exchange rates. IMF Working Paper No. 05/3. Retrieved May 12, 2008, from http://www. imf. org/external/pubs/ft/wp/2005/wp0503. pdf Taylor, M. P. , & Sarno, L. (2001). Official intervention in the foreign exchange market: Is it effective, and, if so, how does it work?. CEPR Discussion Paper No. 2690. Retrieved May 12, 2008, from http://papers. ssrn. com/sol3/papers. cfm? abstract_id=261856#PaperDownload
