4.4: Exchange Rates

What is foreign exchange?

Trading different currencies to make transactions with other countries.

What influences the market of foreign exchange?

Demand and supply of currencies.

What are exchange rates?

Value of one currency in terms of another.

What is a floating exchange rate?

When the exchange rate is determined purely by market forces; set at equilibrium; no intervention.

What is appreciation?

Increase in the value of a currency.

What causes appreciation? (2)

- Increase in demand.

- Decrease in supply.

What causes depreciation? (2)

- Decrease in demand.

- Increase in supply.

What can change demand for a currency? (8)

- Foreign demand for exports.

- Relative inflation rates.

- Relative growth rates.

- Inward FDI and portfolio investment.

- Relative interest rates.

- Inward flows of remittances.

- Speculation of appreciation.

- Central bank intervention.

Why does the foreign demand for exports impact the demand for a currency?

When foreigners demand for exports, they also demand for the currency in order to make the transaction.

How does increased foreign demand for exports impact currency demand?

Increased demand for currency.

How does decreased foreign demand for exports impact currency demand?

Decreased demand for currency.

Why do the relative inflation rates impact the demand for a currency?

Inflation influences the general price level; impacts price of exports and imports.

How does lower inflation impact currency demand?

Exports are cheaper; increased demand for currency.

How does higher inflation impact currency demand?

Exports are expensive; decreased demand for currency.

Why do the relative growth rates impact the demand for a currency?

Economic growth influences incomes and thus demand for exports.

How does higher foreign growth rates impact currency demand?

Incomes of foreign consumers increase; more demand for exports; increased demand for currency.

How does lower foreign growth rates impact currency demand?

Incomes of foreign consumers decrease; less demand for exports; decreased demand for currency.

Why does inward FDI and portfolio investment impact the demand for a currency?

Inward investment, foreigners demand domestic currency.

How does increased inward FDI and portfolio investment impact currency demand?

Demand for currency increases.

How does decreased inward FDI and portfolio investment impact currency demand?

Demand for currency decreases.

Why do the relative interest rates impact the demand for a currency?

Interest rates determine attractiveness of investments.

How do high interest rates impact the demand for a currency?

Investments more attractive; increased demand for currency.

How do low interest rates impact the demand for a currency?

Investments less attractive; decreased demand for currency.

What are remittances?

Transfer of money from a foreign worker to their home country.

Why do inward flows of remittances impact the demand for a currency?

More of the home currency is being demanded.

How do increased inward remittances impact the demand for a currency?

Demand for currency increases.

How do decreased inward remittances impact the demand for a currency?

Demand for currency decreases.

What is currency speculation?

Buying and selling of currencies to profit from exchange rate fluctuation.

Why does speculation of appreciation increase demand for a currency?

A currency that may appreciate is bought so that it can be sold later on to make profit; increased demand.

Why does central bank intervention impact the demand for a currency?

Central banks manipulate demand and supply of currencies to manipulate exchange rates

How does the central bank increase the demand for a currency?

To increase exchange rate, central bank buys more of the currency; increases demand.

What can change supply for a currency? (8)

- Foreign demand for exports.

- Relative inflation rates.

- Relative growth rates.

- Inward FDI and portfolio investment.

- Relative interest rates.

- Inward flows of remittances.

- Speculation of appreciation.

- Central bank intervention.

Why does domestic demand for imports impact the supply of a currency?

Importing requires buying another currency buy supplying own currency.

How does increased domestic demand for imports impact currency supply?

More domestic currency is exchanged; increased currency supply.

How does decreased domestic demand for imports impact currency supply?

Less domestic currency is exchanged; decreased currency supply.

Why do the relative inflation rates impact the supply of a currency?

Inflation influences price levels, which determines demand for imports, which influences currency supply.

How do higher relative inflation rates impact currency supply?

Imports are cheaper, demand for imports increase, supply of domestic currency increases.

How do lower relative inflation rates impact currency supply?

Imports are more expensive, demand for imports decrease, supply of domestic currency decreases.

Why do the relative growth rates impact the supply of a currency?

Growth influences incomes which impacts demand for imports.

How do higher relative growth rates impact currency supply?

Higher incomes, demand for imports increase, supply of domestic currency increases.

How do lower relative growth rates impact currency supply?

Lower incomes, demand for imports decrease, supply of domestic currency decreases.

Why does outward FDI and portfolio investment impact the supply of a currency?

Outward investment requires supplying domestic currency overseas.

How does increased outward FDI and portfolio investment impact currency supply?

More currency is being supplied overseas; supply of currency increases.

How does decreased outward FDI and portfolio investment impact currency supply?

Less currency is being supplied overseas; supply of currency decreases.

Why does the outflow flow of remittances impact the supply of a currency?

Sending remittances overseas increases supply of currency.

How do higher relative domestic interest rates impact currency supply?

Less attractive to invest overseas, supply of currency decreases.

How do lower relative domestic interest rates impact currency supply?

More attractive to invest overseas, supply of currency increases.

How does the speculation that a currency will depreciate impact the supply of a currency?

Speculators sell now and buy later to profit; supply increases.

How does increased outflow flow of remittances impact currency supply?

More currency supplied overseas; supply of currency increases.

How does decreased outflow flow of remittances impact currency supply?

Less currency supplied overseas; supply of currency decreases.

Why do the relative interest rates impact the supply of a currency?

Interest rates influence attractiveness of investment.

How does central bank intervention impact the supply of a currency?

Central banks supplies/sells domestic currency to decrease exchange rate; increases supply.

What factors effect both demand and supply of currency at the same time? (2)

- Relative inflation rates.

- Relative interest rates.

How do higher inflation rates lead to depreciation? (2)

- Exports are more expensive; decrease in currency demand.

- Imports are cheaper; increase in currency supply.

How do high inflation rates impact the value of a currency?

Depreciation.

How do lower inflation rates lead to appreciation? (2)

- Exports are cheaper; increase in currency demand.

- Imports are expensive; decrease in currency supply.

How do low inflation rates impact the value of a currency?

Appreciation.

How do higher interest rates lead to appreciation? (2)

- Foreign investments attractive; increased currency demand.

- Domestic investments attractive; decreased currency supply.

How do low interest rates impact the value of a currency?

Depreciation.

How do lower interest rates lead to depreciation? (2)

- Foreign investment unattractive; decrease currency demand.

- Domestic investment unattractive; increased currency supply.

How do high interest rates impact the value of a currency?

Appreciation.

What can a change in exchange rate impact? (6)

- Inflation.

- Economic growth.

- Unemployment.

- Current account balance.

- Foreign debt.

- Living standards.

How does appreciation effect demand-pull inflation?

Lower demand-pull inflation.

Why does appreciation lower demand-pull inflation?

Exports expensive (decrease), imports cheaper (increase); net exports decrease.

How does depreciation effect demand-pull inflation?

Greater demand-pull inflation.

Why does depreciation increase demand-pull inflation?

Exports cheaper (increase), imports expensive (decrease); net exports increase.

How does appreciation effect cost-push inflation?

Lower cost-push inflation.

Why does appreciation decrease cost-push inflation?

Imports are cheaper; lowers production costs.

How does depreciation effect cost-push inflation?

Greater cost-push inflation.

Why does depreciation increase cost-push inflation?

Imports are more expensive; production costs increase.

How does appreciation effect economic growth? (2)

- Net exports reduce.

- Imports increase may help importing industries grow.

What determines the effect of appreciation on economic growth?

Which effect is more significant:

- Decreased AD due to lower net exports.

- Increased AS due to increased investment by import industry.

How does depreciation effect economic growth? (2)

- Net exports increase.

- Imports decrease may impact importing industries.

What determines the effect of depreciation on economic growth?

Which effect is more significant:

- Increased AD due to greater net exports.

- Decreased AS due to less investment by import industry.

How does appreciation effect unemployment? (3)

- More unemployment in export industry.

- More unemployment in industries competing with imports.

- Less unemployment in industries which use imports as inputs.

What determines the effect of appreciation on unemployment?

Which effect is more significant:

- More unemployment in export/import competitors industry.

- Less unemployment in industries which use imports as inputs.

How does depreciation effect unemployment? (3)

- Less unemployment in export industry.

- Less unemployment in industries competing with imports.

- More unemployment in industries that use imports as inputs.

What determines the effect of depreciation on unemployment?

Which effect is more significant:

- Less unemployment in export/import competitors industry.

- More unemployment in industries that use imports as inputs.

How does appreciation effect the current account balance?

Decreased net exports; worsens current account balance.

How does depreciation effect the current account balance?

Increased net exports; improved current account balance.

How does appreciation effect the value of foreign debt?

Currency is worth more; value of foreign debt decreases.

How does depreciation effect the value of foreign debt?

Currency is worth less; value of foreign debt increases.

How does appreciation effect living standards?

Increases living standards.

Why does appreciation increase living standards? (3)

- Imports are cheaper (holidays, tourism).

- Less demand-pull inflation.

- Real value of incomes increase.

How does depreciation effect living standards?

Decreases living standards.

Why does depreciation decrease living standards? (3)

- Imports are more expensive (holidays, tourism).

- More demand-pull inflation.

- Real value of incomes decrease.

What are fixed exchange rates?

Exchange rates that are fixed to a desired amount; maintained through manipulation by government/central bank

What intervention can be used to maintain fixed exchange rates? (4)

- Buying and selling foreign currency reserves.

- Interest rates.

- Borrowing from abroad.

- Efforts to limit imports.

How can buying and selling of foreign currency reserves maintain the fixed exchange rate?

Used to manipulate demand and supply of domestic currency.

How is a fixed exchange rate maintained using foreign currency reserves if there is excess supply?

Sell foreign currency reserves to buy domestic currency; increases demand and reduces supply of domestic currency.

How is a fixed exchange rate maintained using foreign currency reserves if there is excess demand?

Buy foreign currency by selling domestic currency; decreases demand and increases supply of domestic currency.

How are interest rates used to maintain the fixed exchange rate?

Manipulating interest rates impacts investment from overseas.

How is a fixed exchange rate maintained with interest rates if there is excess demand?

Decrease interest rate to lower investment; decreases demand and increases supply.

How is a fixed exchange rate maintained with interest rates if there is excess supply?

Increase interest rate to attract investment; increases demand and decreases supply.

How is borrowing from abroad used to maintain the fixed exchange rate?

Borrowing increases foreign reserves; used to buy domestic currency to correct excess supply.

How does limiting imports maintain the fixed exchange rate?

Supply of domestic currency decreases, correctly excess supply.

What is devaluation?

Lowering the value of a fixed exchange rate.

What may happen if a currency is too high to be maintained?

Devaluation.

What is the effect of devaluation? (3)

- Exports are cheaper.

- Imports are more expensive.

- Increased net exports.

How does devaluation impact net exports?

Increases net exports.