Foreign Exchange Rates (Forex)
An exchange rate is the price of one currency in terms of another
e.g. £1 = €1.18
o International currencies are essentially products that can be
bought and sold on the foreign exchange market (forex)
The Central Bank of a country controls the exchange rate
system that is used in determining the value of a nation's currency
Two of the main exchange rate systems are
o A floating exchange rate
o A fixed exchange rate
1. A floating exchange rate system
Different currencies can be bought and sold, just like any other
product
The forces of demand and supply determine the rate at which one
currency exchanges for another
As with any market, if there is excess demand for the currency on
the forex market, then prices rise (the currency appreciates)
If there is an excess supply of the currency on the forex market,
then prices fall (the currency depreciates)
The relationship between the US$ and the Euro shows that as
Europeans demand the $ it appreciates but by supplying their
own currency it depreciates
Diagram analysis
The Euro/US$ market is shown by two market diagrams - one for
the USD market on the left and one for the Euro market on the right
The initial exchange rate equilibrium is found at P1Q1 in both
markets
When Europeans visit the USA, they demand US$ and supply Euros
o The increased demand for the US$ shifts the demand
curve to the right which results in the value of the
$ appreciating from P1 → P2 in the USD market and a new
market equilibrium forms at P2Q2
o The increased supply of the Euro shifts the supply curve to
the right which results in the value of the
Euro depreciating from P1 → P2 and a new market equilibrium
forms at P2Q2
2. A fixed exchange rate system
A system in which the country’s Central Bank intervenes in the
currency market to fix (peg) the exchange rate in relation to
another currency e.g US$
o When they want their currency to appreciate, they buy it on
forex markets using their foreign reserves, thus increasing
its demand
o When they want their currency to depreciate, they sell it on
forex markets, thus increasing its supply
Sometimes the peg is at parity e.g. 1 Brunei Dollar = 1 Singapore
Dollar
Often the peg is not at parity e.g. Hong Kong has pegged its
currency to the US$ at a rate of HK$ 7.75 = US$ 1
A revaluation occurs if the Central Bank decides to change the peg
and increase the strength of its currency
A devaluation occurs if the Central Bank decides to change the
peg and decrease the strength of its currency
Evaluating Exchange Rate Systems
An Evaluation of a Floating Exchange Rate Mechanism
Advantages Disadvantages
Natural fluctuations in the
exchange rate based on
demand and supply help
Fluctuations in the exchange rate can create
to maintain stable current
uncertainty for firms, leading to a reduction in
account balances
investment e.g. if a firm provides a quotation to a
If a currency appreciates,
foreign buyer based on today's exchange rate, but
the country's exports fall and
the exchange rate then appreciates, the domestic firm
imports rise
will not make as much profit as expected
If a currency depreciates,
the country's exports rise
and imports fall
Currency appreciation may Currency depreciation may cause costs of imported
allow costs of imported
raw materials to decrease raw materials to increase resulting in cost push
which may help lower prices inflation
in the economy
Lower exchange rates (or a
depreciating
Higher exchange rates (or an appreciating
currency) may help
currency) may reduce/slow down economic
to increase economic
growth as export sales decrease
growth as export sales
increase
Government does not need
to monitor and maintain a
fixed exchange rate
An Evaluation of a Fixed Exchange Rate Mechanism
Advantages Disadvantages
Even with an increasing demand for a
In order to maintain the fixed exchange
country's exports, the price of its exports
rate, the Central Bank has to regularly
will remain fixed as the currency will not
intervene in the currency market by buying
appreciate with more demand or selling its own currency
This can boost export sales over time e.g. This can be an expensive policy to
China did this for many years and its maintain
products remained artificially cheap to buy
Changing the interest rate can also influence
Firms (foreign and domestic) benefit as they the exchange rate
can agree prices with a high level of Changing the interest rate to maintain a
certainty as the exchange rate will not fixed exchange rate can have negative
fluctuate consequences on consumption, investment,
lending, saving and borrowing