Exchange rate economics

Exchange rate definition

The price of one currency in terms of another set on the foreign exchange markets

Importance of Exchange rates

they affect international trade, inflation, investment, growth, and employment

What is the foreign exchange (forex) market?

The global market where currencies are bought and sold for trade, investment and speculation 

what is a floating exchange rate? 

when a currency value is determined by demand and supply in the forex market without governmnet intervention 

what is a fixed exchange rate?

A system where a country’s currency value is kept constant against another currency through central bank intervention.

what does pegged mean in exchange rates? 

pegged - means the currency is attached or linked to another currency at a fixed value,

a governmnent may fix its currency value at a set rate compared to another and maintain that rate using central bank intervention 

what is managed float exchange rate? 

a system where the currency is mainly determined by demand and supply but the governmnet occasionally intervenes to prevent major fluctuations 

what is a monetray union ?

a group of countries that share a singel currency and a common montary policy

What determines the value of a currency in a floating system(exchange rate)?

The interaction of demand for a supply of the currency in the forex market

What causes an appreciation in a floating system ?

An increase in demand or a decrease in supply of the currency.

D - increase, S- decrease 

What causes an depreciation in a floating system ?

A decrease in demand or an increase in supply of the currency .

D- decrease, S- increase

What are the main sources of demand for a currency ?

1. Foreign demand for exports 

2. Foreign direct invetsement (FDI) 

3. Portfolio investemnt in domestic assets 

4. Speculative buying 

5. High domestic interest rates 

How does the law of demand apply to currency?

As the currency becomes cheaper, the quantity demanded increases

What are the main sources of supply of a currency?

1. Domestic demand for imports

2. Domestic FDI abroad

3. Portfolio investement abroad ]

4. Speculative selling

5. Lower domestic interest rates

How does the law of supply apply to currency ?

As the currency value rises, the quantity supplied increases

What is appreciation?

A rise in the value of a currency in terms of another

What is depreciation

A fall in the value of a currency in terms of another

How does appreciation affect exports ?

Esxport prices rise, making exports less competative

How does appreciation affect imports?

Import prices fall, making imports cheaper

What are the macroeconomic effects of appreciation

• Lower inflation (cheaper imports)

• Slower economic growth (lower net exports)

• Higher unemployment (export sector contracts)

• Current account deficit likely

How does depreciation affect exports ?

Export prices fall, making exports more competative

How does depreciation affect imports ?

Import prices rise, making imports more expensive

What are the macroeconomic effects of depreciation ?

• Higher inflation (costlier imports)

• Faster economic growth (higher net exports)

• Lower unemployment (export sector expands)

• Current account surplus likely

What happens to the exchange rate when interest rates increase ? 

Currency appreciates as investors move funds into higher-yielding(produce a larger amount) domestic assets 

What happens to the exchange rate when interest rates decrease ?

Currency depreciates as investors move funds abroad for better returns

What is a fixed exchange rate system ?

When the central bank maintains a stable currency value against another currency.

How can a central bank maintain a fixed rate?

• Direct intervention (buying/selling currency)

• Adjusting interest rates to influence capital flows

What are the advantages of a fixed exchange rate system?

• Predictability for trade and investment

• Reduced exchange rate volatility

• Helps control inflation

• Prevents competitive devaluations

• Promotes confidence in the currency

What are the disadvantages of a fixed exchange rate system?

• Loss of independent monetary policy

• Requires large reserves for intervention

• Cannot adjust exchange rate to fix trade deficits

• May cause unemployment if currency is overvalued

• Vulnerable to speculative attacks

What is a monetary union?

A group of countries sharing a single currency and common monetary policy.

What are the advantages of a monetary union?

• Price transparency

• Elimination of exchange rate uncertainty

• Lower transaction costs

• Greater trade and investment integration

What are the disadvantages of a monetary union?

• Loss of individual monetary policy

• Asymmetric shocks (different impacts on member states)

• Fiscal discipline challenges between countries

What is a managed exchange rate system?

A system where the currency’s value is mostly market-determined, but central bank intervenes occasionally.

Why do governments manage exchange rates?

• To reduce volatility

• To correct overvaluation or undervaluation

• To stabilize the economy during crises

overvaluation

A currency is overvalued when its fixed or managed exchange rate is set higher than its market equilibrium level.

→ The government keeps the currency too strong compared to what the market would choose.

undervaluation

A currency is undervalued when its fixed or managed rate is set lower than its market equilibrium level.
The government keeps the currency too weak compared to what the market would set.

What are the advantages of managed exchange rates?

• Stability from intervention

• Flexibility from market influence

• Helps smooth extreme currency movements

What are the disadvantages of managed exchange rates?

• Requires foreign currency reserves

• Lack of transparency in policy decisions

• Can be difficult to sustain during global shocks

What the Central bank does when a currency is overvalued?

Sell foreign reserves to buy its own currency and keep its value up

What does the Central bank does when a currency is undervalued?

Buy foreign currency (increase reserves) to keep its value down