AS — ECONOMICS (9708) MACRO CHAPTER 6 Exchange Rates Topics Lectures Free-Floating Exchange Rate 12 Topic 1 Topic 2: Exchange Rate and Domestic Economy 12AS / MACRO — [NOTES] — CHAPTER 6 TOPIC 1: FREE-FLOATING EXCHANGE RATE Definition | Nominal Exchange Rate: Its the price of domestic currency in terms of external currencies. OR ‘An exchange rate is the rate at which one currency trades for another inthe foreign exchange market. Definition | Free-Floating Exchange Rate: The exchange rate like all other commodities are determined under the force of demand and supply in this system. The demand and supply of the currency in the foreign exchange market determines the equilibrium exchange rate of a currency. So, to understand the concept we look at the THREE variables: 1. Demand for the currency in the foreign market 2. Supply ofthe curreney inthe foreign market 3. Equilibrium exchange rate 1, Demand for the curreney Definition: The demand for the currency have a negative relationship with its price (exchange rate). As we see the diagram below as the exchange rate falls, the demand for the currency increases as itis cheaper to buy that currency. Market for USD Market for UsD change change fo fo a Shifts in the Demand curve Factor Description I. Demand for Good from that | If the demand of the domestic goods is increasing in the foreign market this country ‘would inerease the demand for the currency, hence shifting the demand curve outwards and vice versa Z Interest Rate inthe country | IF the interest rates are higher in the domestic country more people from abroad ‘want to invest in country, leading to a rightward shift in the demand curve, 3. Speculation inthe value of | Ifthe value ofthe domestic currency has a chance to go up in the future, more that currency people would buy it. This shifts the demand curve outwards and vice versa Inward Foreign Direct Tf someone wants to invest in our country, they would demand more of our Investment into the country. | currency to invest. Therefore, an increase in inward FDI leads to an increase in demand whereas a decrease in inward FDI leads to a fall in demand. AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 } 2]AS / MACRO — [NOTES] — CHAPTER 6 2. Supply of the currency in the foreign market Definition: Domestic individuals supply more of their currency in the foreign exchange market when its price (exchange rate) is higher. As we see the diagram below as the exchange rate increases, the supply of the currency increases as it is cheaper to buy that currency, Market for USO Market for USD ehange change fate 4 7 Bee 0 Breed 4 => ‘usnty Qt dS uamty i e tus ofus0| Shifts in the Supply curve Factor Description T. Demand for foreign | If the domestic people demand more imported goods, the supply curve will shift to items in that country the right and vice versa. This is because now more of the domestic currency is being floated in the market 2 Interest rates abroad | Ifthe interest rates are higher abroad more individuals would want to shift their ‘money to the foreign country to eam a high rate of interest hence increasing the supply. 3. Speculation inthe fall_| Ifthe local currency is about to depreciate more people would want to buy more of of that currency. the foreign currency, hence increasing the supply and vice versa “Outward Foreign local residents wants to invest abroad they would demand more of foreign Direct Investment currency and supply local currency to get it currency to invest. Therefore an increase in outward FDI leads to an increase in supply whereas a decrease in outward FDI leads to fallin supply. 3. Equilibrium exchange rate ‘Definition: In a floating exchange rate system, the forces of demand and supply determine the equilibrium. Exchange rate equilibrium is established where demand equals supply. Ewes Market for USD (8) ar Gaansty ots AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 ) 2]4. Depreciation/Appreciation AS / MACRO — [NOTES] — CHAPTER 6 Definition | Depreciation: A fall inthe exchange rate within a floating exchange rate system. Definition | Appreciation: A rise in the exchange rate within a floating exchange rate system. ‘Currency Appreciation ‘Currency Depreciation T, Demand Increases feet) Maat fr US 8) BGT 2. Supply Decreases Maret or USO) 2 st . azar ices ot T. Demand Decreases Mea USD) 2. Supply Increases cuca Marat for USO (8) ara Geayets Advantages and Disadvantages of Free Floating Exchange Rate ‘Advantages Disadvantages I, Automatic correction of BOP: Since there is not govt. intervention the demand and supply forces clear out the surpluses and deficits 2. No need to keep too much foreign reserves: Since the govt. doesn’t plan fo intervene in the foreign exchange market the local currency automatically gets converted into the market current exchange market. 3. Free to choose domestic policy: The govt. can facus ‘on just the domestic demand and leave the BOP correction to the market forces as compared to fixed change rate. I. Unstable Exchange Rate: Due to changes in demand and supply of currency a country experiences rapid fluctuations. 2. Uncertainty for Business and Investment: Exporters and importers will be uncertain about prices of goods and raw material. This will lead to lower business activity and lower investment. 3. Speculation: This leads to hot money flows. Hot money is ragged as the transfer of funds around the slobe in search for best return. AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 ) 3]AS / MACRO — [NOTES] — CHAPTER 6 TOPIC 2: EXCHANGE RATE AND DOMESTIC ECONOMY, 1. Exchange Rate: Depreciation (1) Impact on national income and real output. A fall in the value of exchange rate makes exports cheaper in terms of foreign currency and imports expensive in terms of domestic currency. This causes domestic firms to sell more products both home and abroad. Some domestic consumers may new purchase home-made products rather than the expensive imported items. Foreigners buy more due to the price being low. This rise in net exports causes AD to increase and increase ‘output and national income, (2) Impact on domestic price level Demand-Pull Inflation: When the currency value falls this makes exports cheap and imports expensive. This causes the AD to rise therefore inereasing demand:-pull inflation Cost-Push Inflation: When the currency falls this makes imported raw materials and factors of production expensive. This causes the AS to increase therefore increasing cost-push inflation 3) Impact on employment Since the demand for local products and imported products increases firms will likely employ more workers t© expand their output which can reduce cyclical unemployment. 2. Exchange Rate: Appreciati (1) Impact on national income and real output. An appreciation will make exports more expensive in terms of foreign currencies, and imports cheaper in terms of the domestic currency. This is likely to result in a fall in the demand for domestic products. This could result in a slowdown in economic growth or possibly even a recession, This lowers output and incomes will fll. 2) Impact on domestic price level Demand-Pull Inflation; When the currency value rises this makes exports expensive and imports cheap. This ceauses the AD to fall therefore reducing demand: pull inflation. Cost-Push Inflation: When the currency rises this makes imported raw materials and factors of production cheaper. This causes the AS to increase therefore reducing cost-push inflation. (3) Impact on employment Since the demand for local products and imported products increases firms will likely employ more workers 0 expand their output which can reduce cyclical unemployment. AATIK TASNEEM | AS-LEVEL: ECONOMICS (9708) | 03041122845 wi