Foreign exchange rates

Created @January 4, 2024 2:27 PM

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Introduction to exchange rates

Foreign Exchange Rates (Forex)
An exchange rate is the price of one currency in terms of another e.g. £1 =
€1.18

International currencies are essentially products that can be bought & sold
on the foreign exchange market (forex)

The Central Bank of a country controls the exchange rate system that is used
in determining the value of a nation's currency

Two of the main exchange rate systems are

A floating exchange rate

A fixed exchange rate

1. A Floating Exchange Rate System

Different currencies can be bought & sold, just like any other product

The forces of demand & supply determine the rate at which one currency
exchanges for another

As with any market, if there is excess demand for the currency on the forex
market, then prices rise (the currency appreciates)

If there is an excess supply of the currency on the forex market, then prices
fall (the currency depreciates)

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 The relationship between the US$ & the Euro shows that as Europeans demand
the $ it appreciates but by supplying their own currency it depreciates
Diagram Analysis

The Euro/US$ market is shown by two market diagrams one for the USD
market on the left & one for the Euro market on the right

The initial exchange rate equilibrium is found at PQ in both markets

When Europeans visit the USA, they demand US$ & supply Euros

The increased demand for the US$ shifts the demand curve to the right
which results in the value of the $ appreciating from P1 → P2 in the USD
market & a new market equilibrium forms at P2Q2

The increased supply of the Euro shifts the supply curve to the right
which results in the value of the Euro depreciating from P2 → P2 & a new
market equilibrium forms at P2Q2

2. A Fixed Exchange Rate System

A system in which the country’s Central Bank intervenes in the currency
market to fix (peg) the exchange rate in relation to another currency e.g US$

When they want their currency to appreciate, they buy it on forex markets
using their foreign reserves, thus increasing its demand

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 When they want their currency to depreciate, they sell it on forex markets,
thus increasing its supply

Sometimes the peg is at parity e.g. 1 Brunei Dollar = 1 Singapore Dollar

Often the peg is not at parity e.g. Hong Kong has pegged its currency to the
US$ at a rate of HK$ 7.75 = US$ 1

A revaluation occurs if the Central Bank decides to change the peg & increase
the strength of its currency

A devaluation occurs if the Central Bank decides to change the peg &
decrease the strength of its currency

Evaluating Exchange Rate Systems

Each exchange rate system has advantages & disadvantages attached

An Evaluation of A Floating Exchange Rate Mechanism

Advantages Disadvantages

• Natural fluctuations in the

exchange rate based on
demand & supply help
• Fluctuations in the exchange rate can create
to maintain stable current
uncertainty for firms, leading to a reduction in
account balances
investment e.g. if a firm provides a quotation to a foreign
• If a currency appreciates, the
buyer based on today's exchange rate, but the
country's exports fall & imports
exchange rate then appreciates, the domestic firm will
rise
not make as much profit as expected
• If a currency depreciates, the
country's exports rise & imports
fall

• Currency appreciation may

allow costs of imported raw
• Currency depreciation may cause costs of imported
materials to decrease which
raw materials to increase resulting in cost push inflation
may help lower prices in the
economy

• Lower exchange rates (or a

• Higher exchange rates (or an appreciating
depreciating currency) may
currency) may reduce/slow down economic growth as
help to increase economic
export sales decrease
growth as export sales increase

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 • Government does not need
to monitor & maintain a fixed
exchange rate

An Evaluation of A Fixed Exchange Rate Mechanism

Advantages Disadvantages

• Even with an increasing demand for a

• In order to maintain the fixed exchange
country's exports, the price of its exports
rate, the Central Bank has to regularly
will remain fixed as the currency will not
intervene in the currency market by buying
appreciate with more demand
or selling its own currency
• This can boost export sales over time e.g.
• This can be an expensive policy to
China did this for many years & its products
maintain
remained artificially cheap to buy

• Changing the interest rate can also

• Firms (foreign & domestic) benefit as they influence the exchange rate
can agree prices with a high level of • Changing the interest rate
certainty as the exchange rate will not to maintain a fixed exchange rate can have
fluctuate negative consequences on consumption,
investment, lending, saving & borrowing

Foreign Exchange rate Fluctuations

Causes of Exchange Rate Fluctuations
Numerous factors influence floating exchange rates, resulting in
an appreciation or depreciation of a currency

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 Factors influencing floating exchange rates

1. Relative interest rates: influence the flow of hot money between countries. If
the UK increases its interest rate, then demand for £'s by foreign investors
increases & the £ appreciates. If the UK decreases its interest rate, then the
supply of £'s increases as investors sell their £'s in favour of other currencies
& the £ depreciates

2. Relative inflation rates: as inflation in the UK rises relative to other countries,

its exports become more expensive so there is less demand for UK products
by foreigners, which means there is less demand for £s & so the £ depreciates

3. Net investment: foreign direct investment (FDI) into the UK creates a demand
for the £ which leads to the £ appreciating. FDI by UK firms abroad creates a
supply of £'s which leads to the £ depreciating

4. The current account: UK exports have to be paid for in £'s. UK imports have
to be paid for in local currencies, which requires £'s to be supplied to the forex
market. Due to this, an increasing net exports will result in an appreciation of
the £ & falling net exports will result in a depreciation of the £

5. Changes in tastes/preferences: As global demand for quinoa increased as it

became fashionable, Bolivia's exports of quinoa increased dramatically which

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 put upward pressure on their currency. Foreigners demanded the Boliviano in
order to pay for the quinoa

6. Speculation: the vast majority of currency trades are speculative. Speculation

occurs when traders buy a currency in the expectation that it will be worth
more in the short to medium term, at which point they will sell it to realise a
profit

7. Quantitative easing: involves increasing the money supply & much of the new
supply is used to buy back gilts. Many of these gilts are owned by
foreigners who then exchange the £s received for their own currency. The
increase in the supply of £'s depreciates the £

8. MNCs: An increase in the number of MNCs globally will result in more money
flows between countries, each of which influences exchange rates

Consequences of Foreign Exchange Rate Fluctuations

Changes to exchange rates may have far-reaching impacts on an economy

The impact of changes to exchange rates on an economy

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 Economic
Explanation
Indicator

• From a UK perspective, the depreciation of the £ causes exports to

be cheaper for foreigners to buy & imports to the UK are more
expensive
• The
extent to which a currency depreciation improves the current
account balance depends on the price elasticity of demand for
exports & imports
The Current
◦ This follows the
Account
revenue rule which states that in order to increase revenue, firms
should lower prices for products that are price elastic in demand
◦ If the
price elasticity of demand for UK exports is elastic, then a
depreciation of the currency will result in a larger than proportional
increase in demand for UK exports, which will rapidly improve
any current account deficit

• Net exports are a component of total (aggregate) demand

Economic growth ◦ A depreciation that results in an
increase in net exports will lead to economic growth

• Cost push inflation can be caused by a depreciating currency as

the price of imported raw materials increases with a weaker currency
• Net exports are a component of
total (aggregate) demand
◦A
Inflation depreciation that results in an increase in net exports will lead to an
increase in total demand
◦ This may lead to an increase in
demand pull inflation
• An
appreciation of the currency will have the opposite effect

• If depreciation leads to an increase in exports, unemployment is

likely to fall as more workers are required to produce the additional
Unemployment products demanded
• An
appreciation of the currency will have the opposite effect

Living standards • The impact of a depreciation on living standards can be muted

◦ As imports are more expensive, households face
higher prices & less choice, which detracts from living standards

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 ◦ Rising exports can decrease unemployment &
increase wages/income which means an improved standard of living
for some households
• The impact of an
appreciation on living standards will be the opposite

• Depreciation of a currency makes it cheaper for foreign firms to

Foreign direct
invest in the country which can increase investment & real GDP
investment (FDI)
• An appreciation has the opposite effect

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