Chap 26 Exchange rate

Chapter 26: The Exchange Rate

Overview

  • Popular currencies include the dollar ($), euro (€), and yen (¥).

  • The value of currencies, such as the Saudi Riyal, is influenced by various economic factors.

The Foreign Exchange Market

  • To purchase goods/services from other countries, we need foreign currencies, traded in the foreign exchange market.

  • This market allows for the exchange of one country's currency for another.

Exchange Rates

  • Definition: The price of one currency in terms of another.

  • Currency Depreciation: A fall in value of a currency.

  • Currency Appreciation: A rise in value of a currency.

  • The Saudi Riyal is traded continuously by numerous participants, making the foreign exchange market competitive.

Exchange Rate Policies

  • Flexible Exchange Rate: Determined by supply and demand, no central bank intervention.

  • Fixed Exchange Rate: Pegged at a government-decided value, requires active intervention by the central bank.

  • Managed Exchange Rate: Mostly determined by market forces with occasional government intervention.

Supply and Demand Analysis

  • The foreign exchange market analysis utilizes the supply and demand model.

  • Law of Demand: Higher exchange rates reduce the quantity of a currency demanded.

  • Law of Supply: Higher exchange rates increase the quantity of a currency supplied.

Market Equilibrium

  • Equilibrium occurs when market demand and supply balance each other, establishing a stable exchange rate.

  • Surplus or shortage in the market prompts adjustments towards equilibrium.

Factors Influencing Demand and Supply

  • Demand for U.S. Dollars:

    • Influences: World demand for U.S. exports, U.S. interest rates vs foreign rates, expected future exchange rates.

  • Supply of U.S. Dollars:

    • Influences: U.S. demand for imports, expected future exchange rates.

  • Changes in demand/supply lead to fluctuations in exchange rates.

Saudi Arabia's Exchange Rate Policy

  • Saudi Arabia maintains a fixed exchange rate since 1986, officially set at SAR 1 = 0.266667 $ (3.75 SAR = 1 $).

  • The Central Bank intervenes to stabilize this rate by buying and selling Saudi Riyals.

Exchange Rate Policy Considerations

  • Floating Exchange Rates: Central Bank focuses on inflation and unemployment.

  • Fixed Exchange Rates: Stabilizes investor expectations but may limit monetary policy flexibility. Beneficial for developing nations to reduce uncertainty.