GLOBAL

ECONOMICS
Exchange Rates

Ms. Joy Sameh

Phone Number: +20127752891

 Types of Exchange Rate Systems

Foreign Exchange Rates

• 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 & 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

• Three of the main exchange rate systems are

o A floating exchange rate
o A fixed exchange rate
o A managed exchange rate

1. A Floating Exchange Rate System

• DiHerent 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 form 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 form at P2Q2

Floating Exchange Rate Calculations

• As the value of a currency appreciates or depreciates, the value of any international

transaction changes
• These changes can be significant for firms during times of exchange rate volatility
Worked Example
Marsha is a currency trader who buys and sells currency in order to make a profit. Currently,
she is holding €200,000 and expects that the Pound will appreciate against the € in the next
few months.
At present £1 = €1.10

1. Marsha exchanges her Euros for Pounds. Calculate the quantity of Pounds she will
receive for €200,000 [1]
2. The Pound depreciates against the Euro by 10%. Fearing further depreciation, Marsha
changes her Pounds back to Euros. Calculate the loss she has made. [3]

Answer:
Step 1: Calculate the quantity of Pounds received for 200,000

200,000= £ 181 ,818. 18

1. 1

Step 2: Calculate the new exchange rate

£1= (€1.10 x 0.9) = €0.99

Step 3: Use the above value to calculate the new amount of Euros

£ 181 ,818 . 18 x 0.99 = £180,000

(correct answer rounded to 2 decimal places)

Step 4: Calculate the loss

£200,000 - £180,000 = £20,000 loss
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
The Hong Kong Monetary Authority intervenes to maintain the exchange
rate of HK$ 7.75 = US$ 1

Diagram Analysis

• The HK$/US$ market is shown by two market diagrams - one for the HK$ market on
the left and one for the US$ market on the right
• The initial exchange rate equilibrium is found at HK$ 7.75 = US$ 1 - represented by
point 1
• When Hong Kong firms import goods from the USA, they demand US$ to pay for them
and supply HK$
• This impacts the market for each currency - the US$ appreciates and the HK$
depreciates
• To maintain the fixed exchange rate at HK$ 7.75 = US$ 1, the Hong Kong Monetary
Authority intervenes in the forex market by using US$ from its foreign reserves to buy
HK$
Left Diagram - HK$
• The increased supply of the HK$ shifts the supply curve to the right which results in
the value of the HK$ depreciating from (HK$7.75 = $1) → (HK$7.75 = $0.97) and a new
market equilibrium form at point 2
• The Monetary Authority intervenes by buying HK$ which shifts the demand curve right
from D1 → D2
• The HK$ has now been moved back to its target value of K$ 7.75 = US$ 1 - point 3

Right Diagram - US$

• The increased demand for the US$ shifts the demand curve to the right which results
in the value of the US$ appreciating from ($1 = HK$7.75) → ($1 = HK$7.98) and a new
market equilibrium form at point 2
• The Monetary Authority intervenes by buying HK$ using UD$ which increases their
supply shifting the supply curve right from S1 → S2
• The HK$ has now been moved back to its target value of K$ 7.75 = US$ 1 - point 3
3. A Managed Exchange Rate System

• The exchange rate is allowed to fluctuate within a specified band around a desired
valuation. If it goes outside of this band, then the Central Bank will intervene to bring it
back within the band
o When they want their currency to appreciate to back within the band, they buy
it on forex markets using their foreign reserves, thus increasing its demand
o When they want their currency to depreciate back into the band, they sell it on
forex markets, thus increasing its supply
• Currently, almost all currencies are managed currencies
o The width of the band varies from country to country
o These bands are not published as it would help currency speculators to know
when currency reversals would be initiated by the Central bank and they would
seek to profit from that knowledge
 The Peoples Bank of China intervenes to maintain the exchange rate within a specified
band of trading and is in the region of 2% around a value of 1US$ = 6.75 CNY
Diagram Analysis
• China has not released their currency bands; however, the value seems to fluctuate up
to 2% around a value of 1US$ = 6.75 CNY
• The initial market equilibrium is found at ER1 Q1

Action to correct currency appreciation

• Increased demand for the Chinese Yuan leads to a rightward shift of demand D1→D2 leading
to an appreciation from ER1→ER2

• The currency is approaching the upper band so the Peoples Bank of China intervenes by
selling their own currency (and buying foreign reserves)

o This increases the supply of the Yuan causing a rightward shift from S1→S2
o A new equilibrium is established at ER1Q3, well within the band

Action to correct currency depreciation

• Increased supply of the Chinese Yuan on world markets leads to a rightward shift of supply
from S1→S2 leading to a depreciation from ER1 towards the bottom currency band
• The currency is approaching the bottom band so the Peoples Bank of China intervenes by
buying their own currency (and selling foreign reserves)
o This increases the demand of the Yuan causing a rightward shift from D1→D2
o A new equilibrium is established at ER1Q3, well within the band.
Causes & Consequences of Exchange Rate Fluctuations

Causes of Exchange Rate Fluctuations

• Numerous factors influence floating exchange rates, resulting in an appreciation or
depreciation of a currency

Factors influencing floating exchange rates

1. Relative interest rates: influence the flow of hot money between countries. If the UK
increases its interest rate, then demand for £'s by foreign investors increases and the £
appreciates. If the UK decreases its interest rate, then the supply of £'s increases as
investors sell their £'s in favour of other currencies and the £ depreciates

2. Relative inflation rates: as inflation in the UK rises relative to other countries, its exports
become more expensive so there is less demand for UK products by foreigners, which
means there is less demand for £s and so the £ depreciates

3. Net foreign direct investment (FDI): FDI into the UK creates a demand for the £ which
leads to the £ appreciating. FDI by UK firms abroad creates a supply of £'s which leads to
the £ depreciating

4. The current account: EU exports have to be paid for in €'s. EU imports have to be paid for
in local currencies, which requires €'s to be supplied to the forex market. Due to this, an
increasing net exports will result in an appreciation of the € and falling net exports will
result in a depreciation of the €

5. Changes in tastes/preferences: As global demand for quinoa increased as it became

fashionable, Bolivia's exports of quinoa increased dramatically which put upward
pressure on their currency. Foreigners demanded the Boliviano in order to pay for the
quinoa
6. Speculation: the vast majority of currency trades are speculative. Speculation occurs
when traders buy a currency in the expectation that it will be worth more in the short to
medium term, at which point they will sell it to realise a profit

7. Net Portfolio Investment: Portfolio investment into the UK creates a demand for the £
which leads to the £ appreciating. Portfolio investment by UK firms abroad creates a
supply of £'s which leads to the £ depreciating

8. Remittances: Some countries receive high levels of remittances which help to keep the
demand for their currency strong e.g. the Philippines

9. Relative growth rates: Countries with stronger economic growth rates will attract higher
levels of FDI resulting in an appreciation of their currency

10. Central Bank intervention: Any form of monetary policy is likely to influence exchange
rates e.g. higher interest rates will increase the hot money flows. Direct intervention using
foreign reserves will also influence the exchange rate
 Consequences of Foreign Exchange Rate
Fluctuations
• Changes to exchange rates may have far-reaching impacts on an economy

1. Likely impact on the macro economy of a currency depreciation

A depreciation means that imports are more expensive and exports are cheaper. Net
exports should rise leading to an increase in AD from AD1 → AD2
2. Likely impact on the macro economy of a currency appreciation

An appreciation means that imports are cheaper, and exports are more expensive. Net exports
should fall leading to a decrease in AD from AD1 → AD2
Impact of an Appreciation or Depreciation on the Economic
Indicators

Economic Indicator Explanation

• From a UK perspective, the depreciation of the £ causes exports to be
cheaper for foreigners to buy and imports to the UK are more
expensive
• The extent to which a currency depreciation improves the current
account balance depends on the price elasticity of demand for
The Current Account exports and imports
• This follows the revenue rule which states that in order to increase
revenue, firms should lower prices for products that are price elastic
in demand
• If the price elasticity of demand for UK exports is elastic, then
depreciation of the currency will result in a larger than proportional
increase in demand for UK exports, which will rapidly improve any
current account deficit
• Net exports are a component of aggregate demand
• A depreciation that results in an increase in net exports will lead to
Economic growth economic growth

Inflation • Cost-push inflation can be caused by a depreciating currency as the

price of imported raw materials increases with a weaker currency
• Net exports are a component of aggregate demand
• A depreciation that results in an increase in net exports will lead to
an increase in aggregate demand
• This may lead to an increase in demand-pull inflation
• An appreciation of the currency will have the opposite eHect
Unemployment • If depreciation leads to an increase in exports, unemployment is
likely to fall as more workers are required to produce the additional
products demanded
• An appreciation of the currency will have the opposite eHect
Living Standards • The impact of depreciation on living standards can be muted
• As imports are more expensive, households face higher prices and
less choice, which detracts from living standards
• Rising exports can decrease unemployment and increase
wages/income which means an improved standard of living for some
households
• The impact of an appreciation of living standards will be the opposite
Fixed Versus Floating Exchange rate Systems

Comparing Fixed & Floating Exchange Rate Systems

• Many countries have attempted to use fixed exchange rate systems at some point in
their history
• Changes to the global or national equilibrium may cause Central Banks to consider
which system may be most beneficial to achieving their macroeconomic goals at a
specific point in time
o A fixed exchange rate system oHers stability, reduces speculative activities, but
limits monetary policy autonomy
o A floating exchange rate system allows for flexibility in monetary policy,
automatic adjustments to economic conditions, but introduces greater
exchange rate volatility
• The choice between the two systems depends on a country's macroeconomic goals,
stability objectives, and the external economic environment

A Comparison of a Fixed and Floating Exchange Rate System

Fixed Exchange Rate System Floating Exchange Rate System

The central bank actively intervenes to The currency's value is determined by market forces
maintain the fixed rate of supply and demand

Provides stability and predictability for Allows for greater flexibility in conducting
international trade and investment independent monetary policy as interest rates and
the money supply can be more easily manipulated

Limits a country's ability to independently Allows for automatic adjustments to external

conduct monetary policy as the focus is on shocks and changes in economic fundamentals
exchange rate and not the interest rate Markets respond to changing fundamentals without
the need for central bank intervention

Lowers speculative trading and currency

volatility
Changing from one System to the Other

Central Banks have to consider the impact of changing from one exchange rate system to
another

• In January 2015 the Swiss Central Bank removed the fixed exchange rate (peg) of €1 =
1.2 CHF and allowed the currency to float freely
• They did this because:
o In the face of ongoing significant demand for their own currency, the Central
Bank was using enormous reserves to supply more CHF to the market in order
to maintain the peg
o They could no longer abord to supply their own currency
o The demand for their currency was partly driven by deteriorating conditions in
Russia as Russia had taken over the Crimea, which caused investors to seek
safe haven for their money in Switzerland.
 The Implications of Changing from one System to Another - Real World Example

Impact Explanation

Currency Appreciation The Swiss Franc (CHF) experienced a significant increase in value
against the Euro (EUR) as investors demanded it

Export Swiss exporters faced diHiculties as the stronger Swiss Francmade

Challenges their products more expensive and less competitive ininternational
markets

Impact on tourism The higher Swiss Franc made Switzerland a more expensive destination
for foreign tourists, leading to a decrease in tourism revenue

Financial Market The sudden and unexpected appreciation of the Swiss Franc caused
Turmoil market turbulence and financial losses for investors holding Swiss
Franc-denominated assets

Deflationary Pressure The currency appreciation increased deflationary pressures in

Switzerland, as imported goods became cheaper and domestic
producers faced greater competition

Monetary Policy The Swiss National Bank faced challenges in managing the exchange
Challenges rate and preventing excessive appreciation while implementing
independent monetary policy measures

Global Implications The Swiss Franc's appreciation had repercussions beyond Switzerland,
putting pressure on neighbouring countries and trading partners
and aHecting their exports and competitiveness