Exchange Rates

Floating Exchange Rate

Value of currency (expressed in terms of another currency) is determined by demand and supply in the FOREX market with no government intervention

As value of currency increases, what happens to demand and why

demand decreases bc more expensive for foreigners. exports decrease. imports become cheaper

Factors that influence demand and supply of domestic currency

trade, foreign investment, interest rate differential, remittances, speculation, dirty float

how does trade result in appreciation

increase export demand —> demand increase

decrease import demand —> supply decrease

how does foreign investments result in appreciation

if direct/portfolio investments need to purchase domestic currency —> appreciation

how does interest rate differential result in appreciation

percentage difference of two country’s interest rate. if mine higher, will attract more. investors loook for highest rate of returen. thus put savings in our domestic banks which increases domestic demand currency —> appreciation

how does remittances result in appreciation

remittances —> money from overseas

to send back need to convert to domestic currency

how does speculation result in appreciation

speculators buy currency in advance if believe value will increase for profits. thus demand increase

how does dirty float result in appreciation

dirty float —> central bank intervene to stabilize exchange rate in short term by buying/selling domestic currency. also to smooth transition between volatile exchange rate changes

pegged exhange rate

fixed value against another currency. LEDC need because their exchange rate volatile, if fix against another currency will be more stable in case their currnecy depreciates and their loan increases which is bad

depreciation impact —> cost push inflation

cost of production increases so imports more expensive and costs passed onto consumers

depreciation impact —> demand pull inflation

will increase demand because imports more expensive so domestic demand increases and also exports cheaper so foreigners buy more of stuff.

AD increases so production increases so operate closer to productive capacity so shortage so bid up prices

depreciation impact —> unemp and econ growth

increase in AD —> increase in production —> economic growth

—> DDL increase

depreciation impact —> foreign debt

value of debt and interest increases in domestic currency

depreciation impact —> balance of trade

imports become more expensive so decrease

exports become more cheaper for foreigners to buy so increase

Fixed Exchange Rate

value of currency is locked to another currency

how to maintain fixed exchange rate (5)

central bank intervenes in FOREX market to maintain exchange rate

1. buy/sell currency

2. alter interest rates to control capital flows

3. restrict amount of foreign currency can buy

4. limit imports

5. borrow abroad (if want appreciation)

depreciation definition

value of currency decrease in terms of another currency under flexible exchange rate system

devaluation definition

value of currency decrease in terms of another currency under fixed exchange rate system

appreciation

value of currency increase in terms of another currency under flexible exchange rate system

revaluation

value of currency increase in terms of another currency under fixed exchange rate system