Determination of Foreign exchange rate

By Nancy Goel

Determining exchange rates

A flexible or floating exchange rate is where the market forces of supply and demand determine the exchange rate.

A fixed exchange rate is where the government determines the exchange rate for a period of time based on the value of another country’s currency such as the US dollar.

A managed exchange rate is where the government intervenes in the market to influence the exchange rate or set the rate for short periods such as a day or week.

Fixed exchange rates The World Bank and the IMF were both

established in 1944 at a conference of world leaders in Bretton Woods, New Hampshire (USA). The aim of the two "Bretton Woods institutions" as they are sometimes called, was to place the global economy on a sound footing after World War II. To help reduce the economic instability that existed the conference favoured the use of a fixed exchange rate system.

Under a fixed exchange rate system the value of a country’s currency is fixed by the government or one of its agencies, for example the Reserve Bank of Australia (RBA) to another currency for a specific time period.

A fixed exchange rate system does not imply that the rate will stay at that same level all the time. The government may decide to change the rate because of adverse effects on the economy. For example, if the currency is overvalued exporting industries will become less internationally competitive, affecting international trade and the balance of payments and the government might take action to devalue the exchange rate

A devaluation of a currency occurs under a fixed exchange rate system when there isdeliberate action taken by a government to decrease its value in the forex market.

Alternatively a revaluation occurs under a fixed exchange rate system when there isdeliberate action taken by the government to increase the value of the currency in the forex market.

Flexible exchange rate system The value of a nation’s currency, under

a floating exchange rate, is determined by the interaction of supply and demand

The laws of supply and demand show that:Prices of goods, commodities and exchange

rates are determined on open markets under the control of two forces, supply and demand.

1. High supply causes low prices, and high demand causes high prices.

2. When there is an abundant supply of a given commodity then the price should fall.

3. When there is a scarce supply of a given commodity then the price should increase.

4. Therefore, an increase in the demand for a commodity would cause it to appreciate in value, whereas an increase in supply would cause it to depreciate.

Exchange Rate Equilibrium Forces of Demand and Supply Demand for foreign currency negatively

related to the price of foreign currency Supply of foreign currency positively

related to the price of foreign currency Forces of demand and supply together

determine the exchange rate

Relationship between exchange rate and demand for foreign exchange Inverse relationship It means when exchange rate increases

then demand for foreign exchange decreases and vice versa

A) When exchange rate increases When exchange rate increases, the

imports become costlier and importers curtails the demand for imports. Consequently, the dd for foreign currency falls.

B) When exchange rate decreases When exchange rate decreases, the

imports become cheaper and importers increases the demand for imports. Consequently, the demand for foreign currency increases.

Flexible (or floating) exchange rates Under a flexible or floating exchange

rate the value of a country’s currency changes frequently, even by the minute. The market rate will depend on the demand for, and supply of, that currency in the forex markets. When there is no intervention in the free market operations by a government agency a “clean float” is said to exist.

The demand curve (DD) indicates the quantity of Australian dollars that buyers (those people who hold US dollars) are willing to purchase at each possible exchange rate.

The supply curve (SS) shows the quantity of Australian dollars that will be offered for sale (those people who hold Australian dollars) at each exchange rate.

At the equilibrium exchange rate of $A1.00 = $US0.50 the equilibrium quantity supplied and demanded is Q1 Australian dollars. At an exchange rate above equilibrium, such as $A1.00 = $US0.60, an excess supply of Australian dollars exists and market forces will force the exchange rate down towards equilibrium.

If the exchange rate is below equilibrium, such as $A1.00 = $US0.40, an excess demand situation exits and market forces will put upward pressure on the value of the Australian dollar.

A currency appreciation

In Figure 2a there has been an increase in demand (DD to D1D1) for Australian dollars. This has led to an increase (appreciation) in value of the Australian dollar from $US0.50 to $US0.60 and the quantity of Australian dollars traded has also increased from 0Q to 0Q1.

The shift in the demand curve could have been caused by an increase in the demand for Australian exports, such as coal, aluminum, beef or lamb

In Figure 2b there has been a decrease in the supply (SS to S1S1) of Australian dollars. This has led to an increase in the value (appreciation) of the Australian dollar from $US0.50 to $US0.60. However the quantity of Australian dollars traded has decreased from 0Q to 0Q1.

This decrease in the supply of Australian dollars may have been caused by a recession, slowing the demand for imports.

A currency depreciation

In Figure 3a there has been a decrease in demand (DD to D1D1) for Australian dollars. This has led to a depreciation in the value of the Australian dollar from $US0.50 to $US0.40. The quantity of Australian dollars traded has also decreased from 0Q to 0Q1.

The decrease in the price of Australian dollars in terms of US dollars could have been generated by a slow down in global economic activity, so decreasing the demand for Australian exports, or because of foreign investors lacking confidence in the Australian economy and investing elsewhere.

Figure 3b indicates an increase in supply of Australian dollars with the supply curve moving from SS to S1S1. Again the value of the Australian dollar has decreased from $US0.50 to $US0.40 while the quantity of Australian dollars traded has increased from 0Q to 0Q1.

The depreciation may have resulted from strong domestic economic growth increasing the demand for imports, or from higher overseas interest rates, causing a capital outflow from Australia.

Managed exchange rates

A managed exchange rate occurs when there is official intervention by a government or an agency such as the RBA to determination the value of a country’s exchange rate. Through such official interventions it is possible to manage both fixed and floating exchange rates.

The Australia dollar was pegged to TWI from September 1974 to November 1976. Then in November 1976, the government adopted a “managed flexible peg” or a “crawling peg system”. Under this new method of determining exchange rates, the value of the Australian dollar was changed relative to the TWI, not just relative to a single individual currency