Question

Q1a) What determines the value of US dollars in the foreign exchange market?

b) What is optimum currency area?

Answer 1

Q1 a) Firstly I would like to explain the meaning of foreign exchange market

Meaning- The foreign exchange market (also known as forex, FX or the currency market) is an over-the-counter (OTC) global marketplace that determines the exchange rate for currencies around the world. Participants are able to buy, sell, exchange and speculate on currencies.

Which factors determine the value of US dollars in the foreign exchange market.

Introduction

The economy's performance is at the heart of the decision to buy or sell dollars. A strong economy will attract investment from all over the world due to the perceived safety and the ability to achieve an acceptable rate of return on investment. Since investors always seek out the highest yield that is predictable or "safe," an increase in investment, particularly from abroad, creates a strong capital account and a resulting high demand for dollars.

From a currency trading standpoint, when it comes to taking a position in the dollar, the trader needs to assess these different factors that affect the value of the dollar to try to determine a direction or trend.

The methodology of determining dollar value trades can be divided into three groups as follows:-

• Supply and demand factors
• Sentiment and market psychology
• Technical factors

1. Supply Vs. Demand for Driving Dollar Value

When the U.S. exports products or services, it creates a demand for dollars because customers need to pay for goods and services in dollars. Therefore they will have to convert their local currency into dollars by selling their own currency to buy dollars to make the payment. In addition, when the U.S. government or large American corporations issue bonds to raise capital that are then purchased by foreign investors, those payments will also have to be made in dollars. This also applies to the purchase of U.S. corporate stocks from non-U.S. investors, which would require the foreign investor to sell their currency to buy dollars in order to purchase those stocks.

These examples show how the U.S. creates more demand for dollars, and that in turn puts pressure on the supply of dollars, increasing the value of the dollar relative to the currencies being sold to buy dollars. On top of this, the U.S. dollar is considered a safe haven during times of global economic uncertainty, so the demand for dollars can often persist despite fluctuations in the performance of the U.S. economy.

2. Sentiment and Market Psychology of Dollar Value

In the case that the U.S. economy weakens and consumption slows due to increasing unemployment, for instance, the U.S. is confronted with the possibility of a sell-off, which could come in the form of returning the cash from the sale of bonds or stocks in order to return to their local currency. When foreign investors buy back their local currency, it has a dampening effect on the dollar.

3. Technical Factors that Impact the Dollar

Traders are tasked with gauging whether the supply of dollars will be greater or less than the demand for dollars. To help us determine this, we need to pay attention to any news or events that may impact the dollar's value. This includes the release of various government statistics, such as payroll data, GDP data and other economic information that can help us to determine whether there is strength or weakness in the economy.

In addition, we need to incorporate the views of larger players in the market, such as investment banks and asset management firms, to determine the general economic sentiment. Sentiment will often drive the market rather than the economic fundamentals of supply and demand. To add to this mix of prognostication, traders are tasked with analyzing historical patterns generated by seasonal factors such as support and resistance levels and technical indicators. Many traders believe that these patterns are cyclical and can be used to predict future price movements.

Part b) Meaning of optimum currency area

In economics, an optimum currency area or optimal currency region, is a geographical region in which it would maximize economic efficiency to have the entire region share a single currency. The underlying theory describes the optimal characteristics for the merger of currencies or the creation of a new currency.

In simple words we can say,

Optimum currency area theory (OCA) states that specific areas which are not bounded by national borders would benefit from a common currency. In other words, geographic regions may be better off using the same currency instead of each country within that geographic region using its own currency.

OCA theory can benefit a geographic region by significantly increasing trade. However, this trade must outweigh the costs of each country giving up a national currency as an instrument to adjust monetary policy. Areas using OCA theory can still maintain a flexible exchange rate system with the rest of the world.

3 key areas

• Optimal currency area theory states that regions that share certain traits should also share a currency. Multiple countries, parts of multiple countries, or regions within a country may be suited to having their own currency.
• The theory posits that implementing currencies by geographic and geopolitical region, instead of by country, leads to greater economic efficiency.
• An optimal currency area must meet four criteria to qualify, and some economist suggest a fifth.
• Example of the Euro as an Optimum Currency area. I Hope this will help you ?