If the Indonesian rupiah
becomes weaker, is that
good or bad for the
economy?
By the end of this lesson, you will be able to:
➢ Define what an exchange rate is
➢ Floating and fixed exchange rate system
➢ Depreciation and appreciation of currency
➢ Analyse its impact on inflation and trade
➢ How exchange rates are determined using demand and
supply diagrams.”
What is foreign exchange rate?
The foreign exchange rate is the price of one
currency in terms of another currency, that is the
price of domestic currency in terms of a foreign
currency.
For example, 15000 IDR = $ 1 or INR 80 = $ 1
Reasons for Demand for Foreign Currency
➢ Imports of goods and services
➢ Investment in the country
➢ Speculation
➢ Tourism
➢ Remittances
➢ Payment of foreign debt
➢ Education abroad
Floating exchange rate system
A floating exchange rate is one determined by market
forces, i.e. demand and supply. Currencies are bought and
sold on the foreign exchange market which is made up of
financial institutions that buy and sell foreign currency on
behalf of private and business customers.
Currency Depreciation
A fall in the value of currency caused by market forces is known as depreciation or A fall in the value of a currency under
a floating system Example: $1 = 15,000 IDR → $1 = 16,000 IDR IDR has depreciated.
Causes of Depreciation
➢ Increase in imports
➢ Decrease in exports
➢ Lower foreign investment inflows
➢ Higher inflation rate
➢ Political or economic instability
➢ Speculation (selling the currency)
Impact of currency depreciation on national income and real output
Depreciation makes export cheaper in terms of foreign currencies, and imports more expensive, in terms of the
domestic currency.
Rise in net exports will increase aggregate demand which may result in a rise in output and national income.
Currency Depreciation
Impact of a depreciation on domestic price level
➢ The higher aggregate demand due to increase in net exports may give rise to inflationary pressure.
➢ Imported raw material will be expensive which will increase cost of production.
➢ Domestic firms may also feel less competitive pressure to keep costs and prices low.
Impact of a depreciation on unemployment
➢ Increase in unemployment due to higher aggregate demand (Decrease in cyclical unemployment – Caused due to
recession)
Currency Appreciation
A rise in the value of the currency caused by an increase in demand or a decrease in supply is known as an appreciation or A
rise in the value of a currency under a floating system example:
$1 = 15,000 IDR → $1 = 14,000 IDR IDR has appreciated
Causes of Appreciation
➢ Increase in exports
➢ Higher foreign investment inflows
➢ Lower inflation rate
➢ Higher interest rates
➢ Strong economic performance
➢ Speculation (buying the currency)
Impact of currency appreciation on national income and real output
Appreciation makes import cheaper in terms of domestic currencies, and export more expensive, in terms of the foreign
currency.
Fall in net exports will decrease aggregate demand which may result in a fall in output and national income.
Currency Appreciation
Impact of currency appreciation on domestic inflation
Currency appreciation reduces domestic inflation because:
➢ Imports become cheaper
➢ Production costs fall
➢ Aggregate demand decreases
➢ Competitive pressure on domestic firms to restrict price rises
Appreciation leads to lower inflation through cheaper imports and reduced demand pressures.”
Currency Appreciation
Impact of currency appreciation on unemployment
Currency appreciation may increase unemployment as if aggregate demand decreases , firms may not replace
workers who retire and may make some workers redundant.
Test Yourself
1. What does currency appreciation mean?
A. Currency becomes weaker
B. Currency becomes stronger
C. Prices always increase
D. Exports increase
2. If a country’s currency appreciates, what happens to imports?
A. Become more expensive
B. Become cheaper
C. Remain the same
D. Stop completely
3. currency appreciation usually leads to:
A. Higher inflation
B. Lower inflation
C. No change in inflation
D. Hyperinflation
4. Currency appreciation causes Aggregate Demand (AD) to:
A. Increase
B. Decrease
C. Stay constant
D. Double
5. If imported goods become cheaper, what is likely to happen?
A. Cost of production increases
B. Inflation increases
C. Inflation decreases
D. Exports increase
6. Which of the following becomes expensive after appreciation?
A. Imports
B. Exports
C. Raw materials
D. Foreign goods
Measurement of exchange rates
1. Nominal foreign exchange rate – It is the price of one currency in terms of another currency.
Example : 15000 IDR = $1 USD
2. Real exchange rate – A currency value in terms of its real purchasing power. It takes into account price changes as well as
exchange rate changes into account.
Example 1 – Suppose the us dollar:Maxican peso exchange rate is $1 = 20 Pesos and that the US price index is 144 and the
Maxican price index is 120.
Questions – 1. What will be real exchange rate?
2. Decide if the dollar is undervalued or overvalued.
Real exchange rate = Nominal exchange rate x Domestic price index
Foreign price index
Real exchange rate = 20 x 144 = 24
120
Fixed Exchange Rate System
In a fixed exchange rate system the price of the currency is determined by the government. For example if the value of the
UAE’s dirham ma be fixed at 1 dirham = US0.25. The UAE’s central bank will maintain the rate by direct intervention and or
by trying to influence the market demand for and supply of the currency.
Direct intervention involves:
➢ Buying or selling of currencies
➢ Changing interest rates
Advantages of fixed exchange rate system –
➢ It doesn't create uncertainty in the market
➢ Promote international trade and investment
➢ Helps the government to keep inflation low
Disadvantages of fixed exchange rate system –
➢ Government need to keep reserves which involves opportunity cost
➢ Risk of sacrificing other policy objectives in order to maintain the fixed exchange rate.