EXCHANGE RATES The supply of currency

The rate of exchange is the price of one currency in terms of another currency or Foreign currencies are supplied by foreign households, firms, and governments that
currencies on the foreign exchange market. wish to purchase goods, services, or financial assets denominated in the domestic
1$= Rs 42 currency. For example, if a Canadian bank wants to buy a US government bond, it
must sell Canadian dollars. As the price of a foreign currency increases, the quantity
Measuring exchange rates supplied of that currency increases.
• Bi lateral and Multi-lateral rates
A bilateral rate is the rate of exchange of one currency for another, such as £1 Exchange rates are determined just like other prices: by the interaction of supply and
exchanging for $1.50 whereas A multilateral rate is the value of a currency against demand. At the equilibrium exchange rate, the supply and demand for a currency are
more than one other currency. equal. Shifts in the supply or demand for a currency lead to changes in the exchange
• Nominal exchange rate rate.
The nominal exchange rate describes the rate at which an individual can trade the
Appreciation and Depreciation
currency of one country for the currency of another country. That means it measures
how much of currency B can be bought in exchange for currency A or vice versa. The exchange rate for any currency usually fluctuates. When the value of the currency
• Real exchange rate goes up as compared to other currency it is known as appreciation. When the value of
The real exchange rate describes the rate at which an individual can trade the goods currency falls as compared to other currency it is known as depreciation.
and services of one country for the goods and services of another country. That means
it describes how much of a foreign good or service can be exchanged for one unit of a How the value of currency may rise/ appreciate:
domestic product. • Increased demand for that currency on
Real Exchange Rate is the exchange rate after being adjusted for the effects of inflation, world markets
it, therefore, more accurately reflects the purchasing power of a currency. • High exports (the buyers of these
Real Exchange Rate = (Nominal Exchange Rate x Domestic Price) / Foreign Price exports need its currency to pay for those
• Trade weighted index exports)
A trade weighted index is used to measure the effective value of an exchange rate • Increase of interest rates by country's
against a basket of currencies. The importance of other currencies depends on the central bank (people will demand
percentage of trade done with that country. currency to deposit in the banks to earn
that higher interest rate)
The determination of exchange rates • Increase of employment and per capital
income in a country increase, the demand
Floating exchange rate for its goods and services increases, along with demand for that country's currency in
the local market
A floating exchange rate occurs when governments allow the exchange rate to be • Loosening fiscal policy by the government (borrowing money)
determined by market forces and there is no attempt to influence the exchange rate.

The demand for currency

Foreign currencies are demanded by domestic households, firms, and governments

who wish to purchase goods, services, or financial assets that are denominated in the
currency of another economy. For example, if a US auto importer wants to buy a
German car, it must buy euros. The law of demand holds: as the price of a foreign
currency increases, the quantity of that currency demanded will decrease.
 How the value of currency may fall/ depreciate: AD/AS analysis of the impact of exchange rate changes on the domestic economy’s
• Inflationary pressure (inflation equilibrium national income and the level of real output, the price level and
reduces the value of money) employment
• collapse of confidence in an
economy or financial sector The effect of a fall in the exchange rate on the economy
(outflow of capital)
A fall in the exchange rate is likely to improve the current account’s position in the
• lower growth and lower interest
Balance of Payments
rates
• current account deficit (a o This is because the lower exchange rate should cause a fall in the price of exports
country imports more goods and
which would increase export revenue (if PED is elastic) and decrease import
services than it exports)
expenditure (if PED is elastic). This means the (X-M) component of AD will increase
• price of commodities (If an
causing AD to increase. If the economy was previously operating below full capacity
economy depends on exports of
then the increase in AD should increase employment(decrease cyclical unemployment)
raw materials, a fall in the price of this raw material can cause a fall in export revenue
and raise real output.
and a depreciation in the exchange rate).
• Speculation

Causes of changes in a floating exchange rate

Changes in the imports and exports of the country: An increase in exports of a country
will lead to an increase in demand for the currency and thus the value rises.

Changes in Interest rate: Higher interest rate will attract more foreign investors to
invest in the country and thus the demand for currency will rise, resulting in
appreciation in value of the currency.

Changes in Inflation rate: Higher inflation rate will make the country uncompetitive
in the international market. The exports will fall resulting in decreased demand for the
currency and hence lower value.

Rise in domestic income relative to incomes abroad: currency depreciates.

Investment opportunities: if optimistic, lead to appreciation. The fall in the exchange rate may put an upward pressure on inflation for 2 reasons

Speculative sentiments: Individuals and institutions invest in currency markets with 1. The price of imported raw materials will rise thereby increasing the cost of
the sole intention to get short term gains. This is quiet like investing in stock exchange. production further causing an increase in the price of imported finished goods that
Whenever a currency is going strong, people will invest more in an expectation to gain count in the calculation of the country’s inflation rate
from it. This fuels the demand for that particular currency and it appreciates further.
2. Domestic firms will find that imported rival products will be more expensive and
Global trading patterns: if strong global presence in trade then the currency so the domestic firms will be under less pressure to keep their costs and prices low,
appreciates. which may very well lead to a rise in the price level as firms may look to make more
of a profit by increasing prices just lower than the imported rival goods or push any
Changes in relative inflation rates: high inflation rate leads to exports becoming less potential increases in costs of production onto the consumer.
competitive in international market
The effect of a rise in the exchange rate on the economy

It is likely to put a downward pressure on inflation. This is mostly more beneficial if

the economy is operating close or at full employment (AD 1 to AD2).

A higher exchange rate would mean that domestic firms that import products to sell or
import raw materials would now find it cheaper causing their costs of production to
decrease, enabling them to lower their price, making it easier to sell abroad (rightward
shift in AS).

People travelling abroad will find that their currency will buy them more.

Likely to worsen a current account deficit, due to worsened trade balance. An

appreciation will make exports more expensive. Thus, lower exports and higher
imports is likely to lead to a decrease in AD leading to lower real output and lower
employment.