Much trade takes place between nations. For example, Americans buy French cheese and Japanese automobiles, and the French and Japanese buy American airplanes and blue jeans. Most imported good must be paid for in the currency of the selling country. An automobile dealer in the United States who buys Japanese cars gets yen by buying them from a bank at the current exchange rate. An exchange rate is the price of one nation’s currency expressed in terms of another country’s currency. If the exchange rate were 100 yen to the U.S. dollar, the American would have to buy $12,000 in yen to pay for a Japanese auto that cost 1.2 million yen.

   Exchange rates are determined in foreign exchange markets. The rates vary from day to day in relation to international demand for various currencies. If Americans buy more Japanese products, for example, the U.S. demand for yen increases and the yen rises in price against the dollar. This system is known as floating exchange rates or flexible exchange rates. But the United States and many other countries do not allow the rate for their currency to float freely. Each of these countries has holdings of foreign currency. If the exchange rate falls too far, the government will use some of its foreign holdings to buy enough of its own currency to stabilize the exchange rate.

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