It must not be supposed that exchange rates are compounded out of supply of and demand for exchange arising solely from commodity or merchandise trade. There are many kinds of international transactions and any of them which involve money require foreign exchange operations either on the demand or on the supply side of the market. They influence exchange rates just as surely as do exports of automobiles or imports of raw silk and frequently greatly exceed the force of such visible items upon the course of exchange. These nonmerchandise or "invisible" items in the balance of international payments of a country range from transfers of funds to foreign missions to the purchase or sale of securities. A few random examples taken from The New York Times may make more vivid some of the unexpected ways in which foreign exchange rates may be affected.
Consider the whole fabric of foreign exchange rates involving a single currency-for example, the United States dollar. In several score foreign countries dollar exchange is being bought and sold. In the various foreign exchange markets of the United Statesforeign exchange is being traded. From the broadest point of view the supply of dollar exchange abroad is a function of the total imports of goods, services, securities, and gold by Americans, while the supply of foreign exchange in the United States is dependent on the total exports of goods, services, securities, and gold by Americans. The two streams of transactions--import and export-are subdivided into bi-country channels, each one giving rise to pairs of exchange rates, each a product in part of the direct commercial and financial intercourse between the two countries; that is, there is a dollar-sterling rate principally derived from Anglo-American relations, etc. Yet these many pairs of exchange rates are not insulated from interaction. Not only does arbitrage keep each pair in line with the others, but, since international trade is multilateral and not bilateral, the dollarsterling rate, for example, is compounded of exchange transactions in which other countries may have a share.
If exchange rates are competitively determined by the supply of and demand for exchange, the reader may well inquire what limits there are to the fluctuations--short-run and long--in this particular price. To answer such a question is about as easy as to state the limits to fluctuations in the price of copper or sugar or cotton. On the one hand, if competition is rigidly controlled there may be no-or almost no--variation in these prices. On the other hand, if competition is largely unrestrained there is almost, no limit to the fluctuations in them. Always one must distinguish between the surface price-making forces in the market and the underlying factors in price making.
We cannot push further the question of fluctuations in foreign exchange rates and the limits of those fluctuations. We must now turn to an interesting and complicated aspect of foreign exchange rates, the forward market and arbitrage. In the preceding chapter it was explained that the exporter who sells in foreign currency and the importer who buys in foreign currency both assume a risk of fluctuation in exchange rates if the transaction will not be completed for some weeks or months. In such cases, it was stated, the trader may take a speculative chance and assume the risk, or he may by one means or another hedge against or neutralize it. In the next chapter we shall review the considerations which may govern his decision. Here we shall explore the nature of forward exchange rates, since forward exchange is the principal means of hedging exchange risks.
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