EXCHANGE RATE

Factors that affect currency demand

Factors that affect currency demand

1. Increase in currenct demand leads to appreciation.

2. Decrease in currency demand leads ro depreceation.

Increase in currenct demand leads to appreciation.

1. Increase in foreign demand of export

2. Lower inflation: Leading to increase foreign demand for export

3. High growth rate of trading partner leads to increase foreign demand for export.

4. Increase inward investment

5. Higher interest rate: leading to more inward financial investment.

6. Increase inflow remittances

7. Speculators expect currency X will rise so they buy currency X

8. Central bank buys the domestic currency

Inward financial investment

influx of financial capital from foreign investors into a country's financial markets.

Inward investment

Investment of foreign capital into a country.

Decrease in currency demand leads ro depreceation.

1. Decrease in foreign demand of export

2. Higher inflation: Leading to decrease oreign demand for export

3. Low growth rate of trading partner leads to decrease foreign demand for export.

4. Decrease inward investment

5. Lower interest rate: leading to more inward financial investment.

6. Decrease inflow remittances

Remittances

Money that migrants send back to their home countries, usually to support their families or communities.

What does a central bank do when it wants to buy its own currency?

Sells US dollars

What happens to the U.S. dollars when a central bank sells them?

The U.S. dollars become part of the country's currency reserves.

How do countries like Indonesia maintain their currency reserves?

By holding a significant portion of their reserves in U.S. dollars.

What is the purpose of currency reserves for a central bank?

To act as savings and help manage the country's currency and economy.

Country’s currency reserve

It's foreign money, like U.S. dollars, that a country's central bank saves to manage the currency and stabilize the economy.

How does depreceation occurs?

Due to the increase in supply of money, causing the demand to fall

How does appreciation occurs?

Due to fall in supply of money, causing demand to rise

What happens when we purchase foreign products?

We exchange our currency for foreign money, increasing the supply of our currency (demand fall, depreceatiotg6n) and raising the demand for foreign currency, (demand inc, and inc appreciation).

Foreign Exhcange Market

(Forex or FX) is where currencies are bought and sold. It determines exchange rates and allows people and businesses to trade one currency for another.

How to appreciate currency?

1. Reduce import (using protectionism)

2. Increase interest rate (by central bank)

Factors that affect currency demand

1. Decrease in currency supply leads to appreciation

2. Increase in currency supply leads to depreciation

Increase in currency supply leads to depreciation

An Investor from the US incests in the stock market in Brazil

1. US investor has to change the currency to Brazil currency, causing USD to be depreciated.

How do changes in interest rates affect currency value?

Higher interest rates can attract foreign investment, leading to increased demand for the currency and potentially causing its value to appreciate.

Who are the speculators in the foreign exchange market?

Traders who buy and sell currencies to make a profit from changes in exchange rates. They bet on how currencies will move and try to profit from these fluctuations.

Currency speculators believ e that the Brazilian real will appreciate; show the impact on Brazilian real

Appreciate

Japan is in recession and income re falling; show the impact on Japanese yen

value of money decrease, cause demand decrease which causes the currency to get depreciated

China experiences an increase in tourism; show impact on chinese yen

Demand increase, Supply of money increase causing it depreciated

Evaluation Cons of Changes in exchange rate

1. Effect on rate of inflation

Appreciation

1. An increase in the price of export

2. A decrease in the price of import

3. Px (inc), and Pm (dec)

Depreciation

1. A decrease in the price of export

2. An increase in the price of import

Effect of depreciation

1. Effect on the rate of inflation

2. Effect on EG

Depreciation on rate of inflation

Depreciation causes cost push inflation—occurs when the COP increases for businesses, leading them to raise prices for consumers.

How does depreciation cause “cost push inflation”?

It will inc price of imprt, include the price of imported raw materials→If domestic producers are heavily dependent on imported raw materials from overseas, cost of production will be more epxensive and shifting SRAS to the left.

Depreciation could also create what other types of inflation (other than cost push inflation)?

Demand pull inflation

What causes demand pull inflation where there’s depreciation?

Depreciation will decrease the price of export, increase demand of export, increase net export, AD shifts to the right. Price level increase

Depreciation illustration (demand pull inflation)

1. Px (dec) → Dx (inc) → TRx (inc) → Pm (inc)

2. Formula: Spending on m (dec)/ (x-m) (inc))

Depreciation

it will create a higher inflation for the economy due to at the same time, economy will experience cost push, and demand pull inflation

Effect of Depreciation on EG

A currency depreciation—will increas eprice of imported raw materials → decrease SRAS → Decrease RGDP → decrease EG.

Effect of depreciation on foreign debt

Effect of depreciation on standard of living

• Causes increase in inflation → decrease purchasing power → decrease living standard.

• Causes increase in AD → Decrease unemployment → increase living standard

• Causing decrease SRAS → Increase unemployment → decrease living standard.

Effect on Appreciation

Is the vice versa of the effect of depreciation.

Exchange rate systems

1. Floating Exchange Rate System

2. Fixed Exchange Rate System

3. Managed Exchange Rate System

Floating Exchange Rate System

Occurs when the government allow the value of currency to move up/ down freely with no government intervention in foreign exchange market to influence the value of currency.

Appreciation

Value of the currency increases, in the floating exchange rate system

Depreciation

Value of currency decreases, in the floating exchange rate system

Inflation

persistent increase in the price level/ general price level.

Advantages of Appreciation

1. Cheaper price of import, which means more imported goods can be purchased.

2. Hence reducing inflationary pressure, lower prices for consumers

3. It also motivates domestic export producer to improve their efficinecy, so they’re able to compete in the international market.

Disadvantages of Appreciation

1. Level of exports decrease, thus harming the export industry

2. Create higher EU (Structural EU)—Only export industry that is bankrupt, that’s why its structural.

3. Reduce EG

4. Trade balance move towards deficit—bc BOT can be seen from the (x-m).

Advantages of Depreciation

1. Increase export industries—bc cheap prices in export.

2. Reduce EU—produce more output=hire more labour.

3. Improve trade balance.

Disadvantages of Depreciation

1. Create demand pull inflation and cost push inflation

2. Increase inflationary p

Fixed Exchange Rate

• Definition: The value of a currency is set by the central bank and doesn’t change.

• Government and Central Bank Role: They control the currency’s price to keep it stable.

• Purpose: They help maintain a consistent value for the currency in the economy and market.

Devaluation & Revaluation

Changing the value of currenct in the fixed exchange rate system.

Devaluation

is when government decrease the fixed value of the currency in the fixed exchange rate system.

Revaluation

Government increase the currency fixed value in the fixed exchange rate system

Intervention to maintain fixed exchange rate

1. Using official reserve to maintain the exchange rate

2. Increase in interest rate

3. Borrowing from abroad

4. Effort to limit import

How to manage Fixed Exchange Rate

Intervention to maintain Fixed Exchange Rate

1. Using official reserve to maintain the exchange rate (The most effective intervention)

2. Increase in interest rate (can maintain, but it takes time)

3. Borrowing from abroad (can maintain, but it takes time)

4. Effort to limit import (can maintain, but it takes time)

Foreign Currency Reserver (RCF) Purpose

Maintain the value of currency. To change the exchange rate they do it hrough selling/ buying FCR.

How do we decrease/ maintain the price at FCR in Fixed exchange rate?

Purchasing more domestic currency thus causing the supply to incerease which causes the supply curve to shift to the right causing the price to fall.

What happens when there’s an increase in demand for import?

The value of domestic currency will depreciate, due to the fact that import will increase.

Managed Exchange Rate System

Selling FCR

increase or creating more

Overvalued Currency

The government set the value of the currency above the equilibirium price

Undervalued Currency

When the government values the currency below the equilibrium price

Advantages of Overvalued Currency

1. Price of import will be cheaper

2. Made up by the government in developing countries to have cheaper price of capital goof, raw materials and other inputs for the use of production to increase industrialization.

Disadvantages of Overvalued currency

1. Export less competitive → due to price export increasing.

2. May disadvantage domestic producer who must compete with artifically low-price imports.

Advantages of Undervalued currency

1. Export is less expensive to foreign buyers while import becomes mroe expensive domestically

2. Made by developing countries as a method to expand their export industries, expand economy and increase employment level

Disadvantages of Undervalued currency

Advantages Floating Exchange Rate System

1. Central bank no need currency reserves, thus making it a cheap system

2. Gov is free to use monetary policy to achieve goals

3. (N/A)

Advantages Floating Exchange Rate System

1. Central Bank no need currency reserves, therefore, it is cheap system.

2. Government is free to use monetary poliy to achieve domestic goals

3. Trade deficit will be automatically connected.

Disadvantages Floating Exchange Rate System

1. Uncertainty for traders and investors. This tends to decrease both the volume of trade and the volume of cross border investment.

2. The government lacks the policy discipline that a fixed exchange rate system imposes. A country may thus be more prone to inflation

3. There is a room for speculator to do speculation so that they do not necessarily self-adjust in order to eliminate trade deficit.

Advantages of Fixed Exchange Rate System

1. Inflation discipline

2. There is high degree of certainty for firms, consumers and the government, because they know what exchange rate will be in the future. Business will be to plan future investments domestically and abroad. Consumer can better plan to travel abroad, purchases of imported goods and servicea. Government can similarly plan activities involving foreign transactions.

3. Reduce speculation

Disadvantages Fixed Exchange Rate System

1. The government does not free to use monetary policy

2. Trade deficit are not automatically corrected

3. Trade deficit must be corrected by adopting contractionary policy (demand side policy—fiscal policy can be applied) to lower national income. This means that growth will slow down, create a recession and increase unemployment.

Difference between fixed, and flowing exchange rate

Fixed:

• Gov/ central bank

• Devaluation/ revaluation

• No fluctuation

• Stable inflation

• Cant use monetary policy

Floating

• Demand and supply forces

• Appreciation/ depreciation

• Everyday fluctuation

• Unstable inflation

• Can use monetary policy

Balance of Payment (BOP)

Record of all economic transaction between the resident of the country and the resident of all other countries.

Inside of BOP there’s debit and credit transaction. What’s the difference? Credit transaction, every single transaction that can create money inflow INTO the country. Debit transaction, every single transaction that can create money outflow onto other countries.

Under BOP there’s three categories

1. Current Account

2. Capital Account

3. Financial Account

Current Account

Sum of TOB of goods and services, balance of income and the balance of current transfer.