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Understanding Exchange Rate Systems

Exchange rates refer to the price of one currency expressed in terms of another currency. There are two main types of exchange rate systems: fixed and floating. In a fixed exchange rate system, the value of a currency is pegged to another currency. In a floating exchange rate system, the value is determined by supply and demand forces in the foreign exchange market. Appreciation means an increase in a currency's value compared to others in a floating system. Factors affecting exchange rates include demand for domestic products and interest rates, as well as inflation rates and investment prospects. Governments can influence exchange rates through foreign reserves and interest rate changes. Advantages and disadvantages exist for both high and low exchange rates, as well as for fixed and

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64 views3 pages

Understanding Exchange Rate Systems

Exchange rates refer to the price of one currency expressed in terms of another currency. There are two main types of exchange rate systems: fixed and floating. In a fixed exchange rate system, the value of a currency is pegged to another currency. In a floating exchange rate system, the value is determined by supply and demand forces in the foreign exchange market. Appreciation means an increase in a currency's value compared to others in a floating system. Factors affecting exchange rates include demand for domestic products and interest rates, as well as inflation rates and investment prospects. Governments can influence exchange rates through foreign reserves and interest rate changes. Advantages and disadvantages exist for both high and low exchange rates, as well as for fixed and

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TheOnlyNameless
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© All Rights Reserved
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Exchange Rates

Exchange rate: the price of one currency expressed in the terms of other currencies.
Fixed: the price is set/pegged to another currency
Floating: Not fixed, exchange rate is determined by the forces of supply and demand
Flo1ting system: the value of the exchange rate is determined by the supply and demand of the
currency on the foreign exchange market.
Appreciation: an increase in the value of the exchange rate in comparison to other currencies operating
within a floating exchange rate system.
Difference between devaluation vs depreciation:
Both mean the currency looses value, but devaluation is when the government decides to decrease the
value

Factors affecting Exchange rate


Demand

Demand for domestic products

Interest rate (People want to save money in places where they receive the most interest)

Inflation rate (People want to save money where currency does not depreciate

Investment prospects

Speculation

Supply
When a currency has high demand, people buy more of it, and there is less left for others to buy.
Therefore the factors for supply are the opposite as those for demand

Advantages of a high exchange rate

Downward pressure on inflation

More imports can be bought for a lower price

Increases competitiveness of the domestic industries

Disadvantages of a high exchange rate

Damage to domestic industries employment can decrease since imported products are cheaper

can affect balance of paymentsnota

Advantages of a low exchange rate

Greater employment and development for domestic industries

Disadvantages of a low exchange rate

Higher levels of inflation, since imported products are more expensive (cost push inflation)

Methods for the government to affect exchange rate

Foreign reserves the government buys reserves in foreign currencies and things like gold to
that they can use to buy/sell their own currency, to affect the demand and supply for their
currency.

By changing interest rates

Advantages of a fixed exchange rate

Could reduce uncertainty businesses in the economy

Inflation has a higher impact on the demand for exports and imports (The rate is not self
adjusting)

Should reduce speculation if it is set at the correct level

Disadvantages of fixed exchange rates

Cannot use Interest rates to influence other macroeconomic objective

Have to maintain high foreign reserves

It is difficult to determine the correct rate to set the exchange rate to

Can cause international disagreement if the exchange rate is too low, since this can make a
countrys exports more competitive

Advantages of a floating exchange rates

Interest rates can be used to influence other macroeconomic objectives

Exchange rate should adjust itself to ensure the current account is balanced

It isnt necessary to keep foreign reserves

Disadvantages of a floating exchange rate

Can create uncertainty for domestic businesses and in foreign markets

Floating exchange rates may be affected by external factors

Floating exchange rate may worsen existing levels of inflation due to cost-push inflation

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