exchange rates. exchange rates the exchange rate refers to the rate at which national currencies...
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Exchange Rates
Exchange rates
The exchange rate refers to the rate at which national currencies can be exchanged for each
other in the foreign exchange market.
For example, presently:
1 Euro = $1.30, so $1.30 must be given to receive 1 euro, or
$1 = .77 euro, so .77 euros must be given to receive $1
Determining Exchange Rates
So how are these values arrived at? Why can $1 only be exchanged for .77 euros, while 1 euro can
be exchanged for $1.30?
In order to answer that question we must consider two types of exchange rate systems, floating
exchange rates and fixed exchange rates
Floating Exchange Rate System
In the floating (flexible) exchange rate system, currency values are determined by market forces,
aka the forces of supply and demand.
Currencies values are always quoted in reference to another currency, because there is no
independent unit that can be used to express the value of all currencies. Therefore we speak of the
value of the $ compared to the euro, or British pound, or any other currency.
Equilibrium Exchange Rate
Equilibrium Exchange Rate
The previous graph shows the market for British pounds, with the horizontal axis measuring the
quantity of pounds, and the vertical axis measuring the price of pounds in terms of $
The demand and supply curves show demand for and supply of British pounds.
Demand for pounds
U.S. citizens and firms demand pounds in order to do business or travel to the UK. The demand for
British pounds (and all other currencies) is downward sloping because when the price of
pounds in terms of $ falls, US residents buy more pounds.
So if $2 is needed to buy 1 British pound, US residents will buy fewer pounds than if $1 was
needed to buy 1 British pound.
Supply of pounds
The supply of British pounds (and all other currencies) is upward sloping because when the
price of pounds in terms of $ increases, UK residents buy more dollars by supplying pounds.
If a US resident receives only .5 pounds for a dollar, she will supply less dollars than if she were
able to receive .8 pounds per dollar. As the US resident gets more pounds for her dollar, she will supply more dollars to buy cheaper British goods
Equilibrium Exchange Rate
Previously, the equilibrium exchange rate of pounds to dollars was 1 pound = $2. If the exchange rate
changed, and 1 pound was equal to $3, there would be an excess quantity of pounds supplied, as UK residents would want to take advantage of buying “cheaper” US
goods
Conversely, if the exchange rate changed to 1 pound = $1, there would be an excess quantity of pounds demanded, as US residents would want to take
advantage of “cheaper” UK goods
Equilibrium Exchange Rate
So in a freely floating exchange rate system, the equilibrium exchange rate is determined by supply and demand forces.
Currency Appreciation and Depreciation
Exchange rates change on a daily basis depending on how the forces of supply and demand affect
different currencies.
The equilibrium exchange rate is always changing, leading to appreciation and depreciation
of different currencies.
Let’s begin at looking at the ways currencies appreciate
Currency Appreciation
Let’s continue talking about the value of the British pound. What are two scenarios that may occur that can lead to an appreciation of this currency?
Currency Appreciation
The value of the pound (in terms of the $) will appreciate if there is an increase in demand for pounds. How would that look on our diagram?
The value of the pound will also appreciate against the dollar if there is a decrease in supply of
pounds. How would that look on our diagram?
Currency Depreciation
Currencies can and do depreciate as well.
The value of the pound (in terms of the $) will depreciate if there is an decrease in demand for pounds. How would that look on our diagram?
The value of the pound will also depreciate against the dollar if there is a increase in supply of
pounds. How would that look on our diagram?
Practice Question
Suppose US customers have recently become disenchanted with US autos and are more
interested in buying German autos. Using a diagram, show the impacts this would have on:
The value of the $, and of the euro
Which currency will appreciate and which will depreciate?
Causes of changes in exchange rates
Like we said before currency exchange rates are constantly changing. What are some of the economic factors that cause these changes to occur?
Interest rate changes
Let’s assume that interest rates increase in the UK from 4% to 6%, while in the US they remain at 4%.
Smart investors would quickly realize that the smart move would be to convert $ to pounds and
then move that money to a UK financial institution.
Financial capital will flow to countries that have higher rates of interest, thus strengthening
(appreciating) the pound and weakening (depreciating) the $.
Rates of inflation
If Japan experiences rising rates of inflation, this increased price level makes Japanese products more expensive, thus reducing the amount of goods Japan will be able to export abroad.
This decrease in demand for Japanese goods will lead to a decrease in demand for Yen, thus
weakening (depreciating) the Japanese currency against the currency of countries with lower rates
of inflation.
Changes in income
If Vietnam experiences a rapid rise in income levels due to economic growth, residents will
begin importing more foreign goods than previously.
This will lead to an increase in supply of the Vietnamese currency as they exchange their
currency for the currency of foreign producers, and the Vietnamese currency will weaken
(depreciate).
Changes in taste
If Indian goods suddenly become fashionable around the world, foreigners will begin demanding
and importing more Indian goods than before.
To purchase these goods, foreigners will supply their local currency and demand rupees, thus
leading to an appreciation (strengthening) of the Indian rupee.
Speculation
Investors often try to predict changes in the foreign currency markets just like they do in the bond or stock markets. If a trader suspects that
the Mexican peso will appreciate in the near future, he may by pesos and then sell them at a
later date to realize a profit.
The speculative purchase of the peso increases demand for pesos and will have the affect of
appreciating the currency.
Practice Questions
1—Interest rates rise in the US faster than elsewhere. What is the effect on the $ and on the
euro?
2—Inflation rises in Thailand faster than in Singapore. What is the effect on the Thai baht
and Singapore dollar?
3—Currency speculators bet on the South African rand to depreciate. How will the Yen be affected?
More Practice Questions
4—China is in recession and incomes are falling. What will happen to the Chinese yuan?
5—Switzerland welcomes a record number of tourists. How will the Swiss franc react?
6—People around the world discover the beauty of Canadian jewelry. How will the Canadian dollar be
affected?
Imports and Exports
If a country’s currency appreciates, its citizens are in a better position to import foreign goods, but
manufacturers are less able to export their goods abroad.
So when a country sees it’s currency appreciate, oftentimes this will have a negative effect on a
countries balance of trade.
The opposite is true as well, a depreciated currency will lead to more exports and fewer imports
Currency exchange rate fluctuations and the BOP
If EU customers begin importing more US goods, they must supply Euros and demand $, leading to
an appreciation of the $ and a deficit in the EU current account, and a surplus in the US capital
(financial) account.
This would seem to create an imbalance in both countries BOP, but luckily floating exchange rates
can fix this problem…..
Currency exchange rate fluctuations and the BOP
Under floating exchange rates, the currencies will automatically adjust (the $ strengthens and the euro weakens) and create a situation where the quantity of each currency demanded equals the
quantity of each currency supplied.
This change in the value of the currencies will eliminate the imbalance in the BOP without any
outside actions needing to be taken