EXCHANGE RATES
EXCHANGE RATE SYSTEMS AND EFFECTS OF
CHANGES IN THE EXCHANGE RATE
Objectives
• Define foreign exchange rate
• Distinguish between floating and fixed foreign exchange rates
• Explain the determination of foreign exchange rates in the foreign exchange
market
• Analyze the causes of foreign exchange rate fluctuations
• Discuss the consequences of foreign exchange rate fluctuations
Foreign Exchange Market
• Foreign Exchange Market: a money market for trading in foreign currencies. It
consists of the forex bureaus and banks
• The Exchange Rate:
• The price of foreign currency or
• The rate at which a unit of a country’s currency can be exchanged for a unit of another country’s
currency
• The value of a country’s currency expressed in terms of another currency
• How many units of a domestic currency that can be exchange with one unit of a foreign currency
• It is the external value of a currency
Exchange Rate Systems
• An exchange rate system describes the conditions under which one currency can
be exchanged for another.
• There are three basic types of exchange rate systems
• Flexible/Free or Floating Exchange Rate System
• Fixed Exchange Rate System
• Managed Exchange rate system or Dirty Float
Flexible/Floating Exchange Rate System
• It is an exchange rate system in which demand and supply of the currency determines the
value of the currency
• Under a flexible exchange rate system
• Market forces (demand and supply) determines the exchange rate
• There is no government intervention in the market
• The currency appreciates and depreciates in line with changes in market conditions
• Demand for a currency → inflows e.g. exports, inward remittances
• Supply of the currency → outflows e.g. expenditure on imports, repatriation of profits by
MNC
Changes in the exchange rate
Appreciation
• Appreciation is the increase in the external value of a currency in a flexible exchange
rate system[ CEDIS IS GAINING STRENGTH/ STRONGER]
• $1=5cd (c1=0.20cent) old price
• $1=4cd (1cd=0.25 cent) new price
• Conditions
• Increase in demand, supply is constant
• Decrease in supply, demand is constant
• Increase in demand and decrease in supply
Appreciation diagram; Pound
Changes in the exchange rate
Depreciation
• Depreciation is a fall in the external value of a currency in a flexible exchange rate
system[CEDIS IS LOSING STRENGTH/WEAKER]
• $1= 5(cd1=0.20cent) old price
• $1=7cd(cd1=0.14 cent) new price
• Conditions
• Increase in supply, demand is constant
• Decrease in demand, Supply is constant
• Increase in supply and decrease in demand
£/$
• Increased importation of UK goods and
services results in rising supply of dollars on
the foreign exchange market shifting supply
S1 $
of to S2 $. Consequently, at the new
equilibrium the dollar depreciates from $1=
S2 $
£0.65 to £0.53 per dollar.
• Rising imports ( or a deficit in the current
account) causes a depreciation of the
exchange rate.
0.65
0.53
D1 $
Q1 Q2 Amount of Dollars
Depreciation diagram
Causes of Changes in the Exchange Rate
• Changes the current account of the balance of payments
• A rising surplus represents greater demand for the currency which causes an appreciation
• A rising deficit represents greater supply of the currency which may cause a depreciation
• Changes in relative interest rate
• Higher relative interest rate induces inflow of hot money causing an appreciation
• Lower relative interest rate causes an outflow of hot money leading to a depreciation
Causes of Changes in the Exchange Rate
• Relative Inflation Rates
• Lower relative inflation increases competitiveness of exports increasing export demand which increases
the demand for the currency and increases the value exchange rate
• Higher relative inflation makes imports cheaper leading to rising imports which increases supply of the
currency causing a depreciation
• Currency Speculation
• Speculators are those who buy foreign currency solely to resell for profit.
• An anticipated cut in US interest rates might indicate future loss of value of the dollar. Speculators will
immediately sell all their dollars now at a higher value and buy it back later when it falls in order make a
profit. The buying and selling actions of speculators causes changes in the exchange rate.
Causes of Changes in the Exchange Rate
• Relative Income Changes
• The rate of growth in incomes influences demand for imports
• If incomes rise faster in the US than the UK, Americans are likely to demand more foreign
goods increasing the supply of dollars causing a depreciation.
• Conversely, rising incomes in the UK compared to US will cause the sterling to fall and the
dollar to rise
• Political and Economic Uncertainties
• Increased political and uncertainties increases risk causing capital flight (outflow of hot money)
which increases the supply of the currency causing a depreciation.
Causes of Changes in the Exchange Rate
• Remittances
• Inward remittances from citizens living and working abroad increases demand for local currency→
appreciation
• Outward remittances e.g. repatriation of profit by multinationals → increases supply of local currency
→depreciation
• FDI flows
• Inflows of foreign currency by external investors increases the demand for the local currency →
appreciation
• Increased outflows of FDI due to investment by residents in foreign countries →increases supply of
local currency →depreciation
Advantages of Flexible Exchange Rate System
• No need huge foreign currency reserves to influence the exchange rate
• Deficits/surpluses in the current account will self-correct so government
does not need to impose trade restrictions which may cause retaliation
• Government is free to pursue domestic macroeconomic objectives such as
growth, price stability and full employment without external constraints
• The exchange rate adjusts to reflect changes in comparative advantage cause
greater efficiency in allocation of resources
Disadvantages of Flexible Exchange Rate
System
• Greater risk of currency speculation may destabilise the economy
• Greater uncertainty for firms due to frequent changes in the exchange rate
which increases the risk associated with international trade and investment
• Exposed to the volatility of the exchange arate
• Floating exchange rates are prone to fluctuations and are highly volatile by nature. A
currency value against another currency may deteriorate only in one trading day.
Furthermore, the short-term volatility in a floating exchange rate cannot be explained
through macroeconomic fundamentals
• Restricted economic growth or recovery
• The lack of control over floating exchange rates can limit economic growth or recovery.
The negative currency exchange rate movements may lead to serious issues. For example, if
the dollar rises against the euro, it will be more difficult to export to the eurozone from the
U.S. Existing issues may worsen
• If a country is suffering from economic issues, such as unemployment or high inflation,
floating exchange rates may intensify the existing problems. For example, depreciation of a
country’s currency already suffering from high inflation will cause inflation to increase
further due to an increase in demand for goods. Moreover, expensive imports may worsen
the country’s current account.
Fixed Exchange Rate System
• The exchange rate is set by the government
• The central bank intervenes in the foreign exchange market by increasing or
reducing the foreign currency reserves to keep the exchange rate unchanged
• It requires the maintenance of substantial amount of international reserves
• The central bank does not allow market forces to dictate the exchange rate
Changes in the exchange rate
Revaluation
• Revaluation is the increase in the external value of a currency in a fixed exchange
rate system
• $1=5cd (c1=0.20) old price
• $1=4cd (1cd=0.25) new price
• The central bank can increase the external value of a currency by selling(supply) the
foreign currency or by raising the interest rate which attract inflow of hot money
How to increase the value of a currency in a
fixed exchange rate system
Changes in the exchange rate
Devaluation
• Devaluation is the fall in the external value of a currency in a fixed exchange rate system
• $1= 5(cd1=0.20)- old value
• $1=7cd(cd1=0.14)- new a value
• The central bank can reduce the external value of a currency by Buying(demand) the foreign
currency or by lowering the interest rate which attract outflow of hot money
How to decrease the value of a currency in a
fixed exchange rate system
₵/$
The initial exchange rate was ₵4.5
S1 $ to the dollar.
A rise in the demand for dollars
S2 $ causes the cedi to depreciate to
₵5.2 to a dollar.
5.2 However, in a fixed exchange rate
E2 system, the government will
E1 intervene by supply more dollars
4 .5 (depleting its reserves of foreign
currency) causing the supply of
dollars to rise to S2 restoring the
D 2$ exchange rate to ₵4.5 to the
dollar.
D 1$
Q1 Q2 Amount of dollars
Advantages of Fixed Exchange Rate System
• Stability in the exchange rate creates certainty reducing the risks associated
with international trade. This provides greater confidence and promotes
international trade and greater investment.
• It provides greater discipline in the management of the economy
• It reduces the danger for international currency speculation and its
potentially destabilising economic effects
Disadvantages of Fixed Exchange Rate System
• It requires very large reserves to be able to maintain the exchange rate. This
makes it expensive and comes with a huge opportunity cost.
• Domestic macroeconomic objectives may be sacrificed to meet external
objectives
• Defending a currency may involve raising interest rates and this can be both
costly and could lead to job losses and due to falling total spending
• If the exchange rate is not fixed correctly, the over/under valuation may
cause intense speculation
Managed Exchange rate or Dirty Float
Managed or dirty exchange rate system involves:
• no particular exchange rate to which government in committed to maintaining
• the central bank allows market forces to set the exchange rate. However, once in a
while, it intervene to influence the exchange rate through changes in reserves of foreign
currency in line with government’s macroeconomic objectives.
• It has attributes of both fixed and flexible exchange rate systems
• The central bank may set lower and upper limits for the exchange rate and intervene
only when the rate drifts outside the set band
Effects of Appreciation(Revaluation) in the
Exchange Rate
• Merits of Appreciation
• Lowers demand pull inflationary pressures because it makes imports cheaper and
exports dearer. If exports and imports are elastic, AD falls
• It reduces the real value foreign currency denominated debt
• Firms who use imported raw materials experience lower costs of imports which may
reduce cost push inflationary pressures
• It increases confidence in the currency as a good store of value
Effects of Appreciation(Revaluation) in the
Exchange Rate
• Demerits of Currency Appreciation
• Export oriented firms will lose competitiveness as exports become more
expensive. This could lead to job losses in these industries if exports are elastic
• It has a negative effect on the current account(DEFICIT)
• Falling net extorts reduces AD, economic growth and employment
Effects of Depreciation(Devaluation) in the
Exchange Rate
• Merits of Depreciation
• Local producers of imported substitute goods benefit because their products become
relatively cheaper.
• Exports become cheaper in the eyes of foreigners and businesses, which produce for the
export market, may experience increased turnover and profits.
• If the demand for imports and exports are elastic, it will lead to an improvement in the
current account.
• It may result in rising aggregate demand as exports rise and imports fall. This leads to
rising economic growth and rising employment
Effects of Depreciation(Devaluation) in the
Exchange Rate
• Demerits of Depreciation
• Imports become expensive and this makes importers of such goods to raise
their prices. This cuts their profits.
• Importers of raw materials also experience a rise in their costs of production
because raw material costs increase. This increases cost push inflationary
pressures
• The burden of foreign currency denominated debt rises
• It reduces confidence in the currency as a good store of value