Exchange rates

exchange rate

• price of one currency in terms of another

• Central Bank controls the exchange rate system to determine the value of a nations currency

• 3 main types:

  • floating

  • fixed

  • managed

floating exchange rate system

• different currencies can be bought and sold

• forces of demand and supply determine the rate at which one currency exchanges for another

  • if excess demand for currency on forex market, price rises (currency appreciates)

    • foreigners wishing to buy goods from/travel to/save or invest in this country

• if excess supply for currency on forex market, price falls (currency depreciates)

  • citizens of that country wishing buy goods from/travel to/save or invest in foreign countries

floating exchange rate diagram

• initial exchange rate equilibrium at P1Q1 in both markets

• Europeans visit USA, demand US dollars and supply euros

  • increased demand for dollars shifts demand curve to right

  • dollar appreciates from P1 to P2 in USD market, creating new equilibrium at P2Q2

  • increased supply of the Euro shifts supply curve to right, value of euro depreciates from P1 to P2

• calculation:

fixed exchange rate

• involves a commitment by the gov to a single fixed exchange rate

• central bank intervenes in currency market to fix the exchange rate in relation to another currency

  • when they want their currency to appreciate, they buy it on forex markets using their reserves, increasing its demand

  • when they want their currency to depreciate, they sell it on forex markets, increasing its supply

• value of currency is “pegged” to the value of another currency

• revaluation: gov allows value of currency to rise

• devaluation: gov decides to lower value of currency

fixed exchange rate diagram

• diagram 1: increased supply of HK dollar shifts the supply curve right, depreciating the currency

• monetary authority intervenes by buying excess supply of the HK dollar, shifting demand curve to the right

• HK dollar now moved back to its target value (fixed rate) of K$ 7.75 = US$ 1

managed exchange rate system

• periodic government intervention to influence value of currency

  • wants to keep rate in a specific range, intervenes if valuation goes beyond it

• when they want currency to appreciate: they buy it on forex market increasing demand

• when they want it to depreciate: they sell it on forex market, increasing supply

manage exchanged rate diagram

• increased demand for chinese yuan leads to right shift in demand curve, causing appreciation

• currency is approaching upper band of the margin, so china intervenes and sells its own currency, increasing the supply

• supply curve shifts right, new equilibrium established within the range

causes of exchange rate fluctuations

• relative interest rates

  • increase in interest rates = more incentive to save in that country, demand for currency increases, currency appreciates

• relative inflation rates

  • increase in inflation = more expensive exports, less demand for products from foreigners, less demand, currency depreciates

• net foreign direct investment

  • foreigners investing into a country increases demand for currency, currency appreciates

• changes in tastes/preferences

  • global demand for product increases when it becomes trendy, if country specialises in that product their exports increase, demand increases, currency appreciates

• current account

  • increased net exports= appreciation of currency, falling net exports = depreciation

• speculation

  • when traders buy currency in expectation it will be worth more, then sell it to realise a profit

• net portfolio investment

  • portfolio investment into a country increases demand for currency, currency appreciates

• remittances

  • some countries receive high levels of remittances (payments) to keep their currency strong

• relative growth rates

  • countries with strong economic growth rates attract higher rates of foreign investment, currency appreciates

• central bank intervention

  • any form of monetary policy influences exchange rates e.g interest rate fluctuations

consequences of foreign exchange rate fluctuations

• current account

  • depreciation of currency causes exports to be cheaper for foreigners and imports into country to be more expensive

  • extent to which currency depreciation improves current account balance depends on PED for exports/imports

    • if PED elastic, depreciation of currency will result in larger than proportional increase in demand for UK exports, improving any current account deficit

• economic growth

  • net exports component of AD

    • depreciation results in increase in exports leading to economic growth

• inflation

  • cost push inflation can be caused by depreciation of currency, as this increases price of raw imported materials

• unemployment

  • if depreciation leads to increase in exports, unemployment likely to fall as more workers required to produce to keep up w demand

  • appreciation of currency has opposite effect

• living standards

  • depreciation of currency causes limited impact on living standards

    • imports become less expensive, households face higher prices and less choice

    • rising exports can decrease unemployment and increase wages

macroeconomic effect of currency depreciation

macroeconomic effect of currency appreciation