Exchange Rates

Introduction to Exchange Rates and Forex Markets

• Exchange Rate: The value of one country’s currency expressed in terms of another country’s currency

  • Foreign Exchange Markets: where currencies are bought and sold, and exchange rates are determined

  • Appreciation: an increase in a currency values on the forex market

  • Deprecation: a decrease in a currency value

Who demands supplies a currency of a forex market

• consumers who wish to buy imports

• investors who wish to invest in foreign assets

• govt and central banks

Who supplies a currency on a forex market

• foreign consumers who buy domestic goods

• foreign investors who invest in domestic assets

• foreign govt and central banks

exchange rate systems

• floating ER: the value of a currency is determined freely in the forex market by changes in demand and supply

• Managed ER: The value of a currency is closely managed by govt and central bank policy

• Fixed ER: “pegged” system; the value of a currency is fixed against another currency (usually the US dollar)

The Determinants of Exchange Rates in a Floating Exchange Rate System

• Real Exhange Rates: the nominal exchange rate of a currency adjusted for the relative price level in each country

• Floating ER determination

  • T: tastes and preferences of domestic and foreign consumers

  • I: relative interest rates. An increase in relative interest rates will cause an appreciation of a country's currency. A decrease in relative interest rates will cause a depreciation

  • P: Relative price levels (inflation rates): An increase in inflation should cause a depreciation of the currency. A decrease in inflation should cause an appreciation as foreigner would demand more of your relatively cheaper goods

  • S: Speculation: The expectation of an appreciation should cause demand for a currency to rise, and an appreciation. The expectation of a depreciation will cause supply to increase and a depreciation. (not possible under a fixed or managed ER system

  • Y: Relative income levels: An increase in relative incomes at home will cause a depreciation of your currency abroad as domestic consumers demand mare imports. A decrease in relative incomes (GDP growth rates) should cause an appreciation of the domestic currency as domestic consumers demand fewer imports

• Advantages of a floating ER

  • Relatively balanced trade: Persistent deficits or surpluses in trade will not exist

  • CB policy allowed to be used for domestic objectives: Changes in interest rate can be reserved to manage domestic aggregate demand and NOT the exchange rates

• Disadvantages of a floating ER

  • Uncertainty among international investors: Fluctuations in exchange rates lead to uncertainty among foreign investors

  • Imported inflation: If a country depends on imported goods or technology, a volatile floating exchange rate could lead to swings in the domestic price level

Relationship Between Current Balance and Exchange Rates

1. Current Account ➔ Exchange Rates

• If a country has a current account surplus (exports > imports):

  • Foreigners buy more of the country’s goods/services

  • To pay, they demand more of the country’s currency

  • Demand for currency increases → Currency appreciates (gets stronger)

• If a country has a current account deficit (imports > exports):

  • The country demands more foreign goods/services

  • It needs foreign currency to pay for those imports

  • Supply of domestic currency increases (as they sell it for foreign currency) → Currency depreciates (gets weaker)

2. Exchange Rates ➔ Current Account

• If a currency appreciates:

  • Exports become more expensive for foreigners

  • Imports become cheaper for domestic buyers

  • Result: Current account moves toward a deficit (exports ↓, imports ↑)

• If a currency depreciates:

  • Exports become cheaper for foreigners

  • Imports become more expensive for domestic buyers

  • Result: Current account moves toward a surplus (exports ↑, imports ↓)

In short:

• A current account surplus tends to make the currency appreciate

• A current account deficit tends to make the currency depreciate

• And changes in the exchange rate feed back to affect the current account over time

Calculate Different Prices Using Exchange Rates

1. Understanding Exchange Rates

• An exchange rate shows how much one currency is worth compared to another

  • Example: If 1 USD = 0.8 EUR, 1 U.S. dollar can be exchanged for 0.8 euros

2. Converting Prices Between Currencies

• To convert a price, multiply the original price by the exchange rate

  • Example: A product costs $100 USD and 1 USD = 0.8 EUR, so: → $100 × 0.8 = €80

3. Calculating Reverse Exchange Rates

• To find the value of the second currency in terms of the first, take the reciprocal of the exchange rate

  • Example: If 1 USD = 0.8 EUR, then: → 1 EUR = 1 ÷ 0.8 = 1.25 USD

4. Impact of Exchange Rate Fluctuations

• When exchange rates change, the price of goods in other currencies changes.

  • Example:

    • Before: 1 USD = 0.8 EUR → $100 = €80

    • After: 1 USD = 0.9 EUR → $100 = €90

• This shows how currency changes affect prices

5. How to Tell if It’s Depreciation or Appreciation:

• Depreciation = currency loses value (buys less foreign money)

• Appreciation = currency gains value (buys more foreign money)

How to check:

• Compare the exchange rate before and after

  • If 1 unit of your currency buys less → Depreciation

  • If 1 unit of your currency buys more → Appreciation

Example 1

• Before: 1 USD = 0.8 EUR

• After: 1 USD = 0.7 EUR → 1 dollar buys less euros → Dollar depreciated.

Example 2:

• Before: 1 USD = 0.8 EUR

• After: 1 USD = 0.9 EUR → 1 dollar buys more euros → Dollar appreciated.