Foreign exchange rates Revision Notes

Foreign exchange rates represent the price of one country's currency expressed in terms of another country's currency. For example, if 1 US dollar equals 0.85 euros, the exchange rate is 0.85 EUR/USD. These rates are crucial because they determine how much foreign currency you receive when exchanging money, affecting international trade, investment, and travel.

Exchange rates fluctuate due to changes in demand and supply for currencies, influenced by factors such as trade flows, interest rates, and economic stability. Understanding these rates helps businesses and governments manage costs and revenues in international transactions.

• Foreign exchange rate = value of one currency in terms of another.
• Essential for pricing exports and imports.
• Influenced by currency demand and supply dynamics.

In a floating exchange rate system, the value of a currency is determined by the foreign exchange market through supply and demand without direct government control. If demand for a currency rises, its value appreciates; if demand falls, it depreciates.

For example, if UK exports increase, foreign buyers need more British pounds to pay for goods, increasing demand for pounds and causing the exchange rate to rise. Conversely, if investors lose confidence in a currency due to economic instability, demand falls and the currency depreciates.

This system allows automatic adjustment of exchange rates in response to economic conditions but can lead to volatility and uncertainty for traders and investors.

• Currency value set by market forces of demand and supply.
• Exchange rates fluctuate freely.
• Allows automatic economic adjustment but can be volatile.

A fixed exchange rate system involves a government or central bank setting the currency's value relative to another currency or a basket of currencies. The authority intervenes in the foreign exchange market to maintain this fixed rate by buying or selling its own currency.

For instance, if the government fixes its currency at 1 unit = 1 US dollar, but market forces push the currency to depreciate, the central bank will buy its own currency using foreign reserves to support its value. If the currency tends to appreciate, the bank sells its currency to increase supply and reduce its value.

This system provides exchange rate stability, which can encourage trade and investment, but requires large reserves and can be difficult to maintain if market pressures are strong.

• Government sets and maintains currency value.
• Central bank intervenes to keep exchange rate stable.
• Provides stability but requires reserves and control.

Floating and fixed exchange rate systems differ mainly in how currency values are determined and managed. Floating rates respond to market forces and can fluctuate widely, while fixed rates remain stable due to government intervention.

Floating systems offer flexibility and automatic adjustment to economic shocks but can cause uncertainty due to volatility. Fixed systems provide predictability for international trade and investment but can lead to imbalances if the fixed rate does not reflect economic fundamentals.

Choosing between these systems depends on a country's economic priorities, such as controlling inflation, promoting trade, or maintaining monetary independence.

• Floating: market-determined, flexible, volatile.
• Fixed: government-set, stable, requires intervention.
• Trade-off between stability and flexibility.

Suppose a UK exporter sells machinery to the US. Under a floating exchange rate, if the pound strengthens against the dollar, the US buyer pays more in dollars, potentially reducing demand. Under a fixed system, the exchange rate remains stable, so prices in dollars stay predictable, aiding planning.

This example shows how exchange rate systems affect international business decisions and pricing strategies.

• Floating rates can cause export prices to vary.
• Fixed rates provide price certainty for trade.
• Businesses must manage exchange rate risks accordingly.

Foreign exchange rates represent the price of one currency expressed in terms of another. These rates fluctuate continuously due to the dynamic interaction of buyers and sellers in the foreign exchange market. Understanding how these rates are determined is essential for analysing international trade, investment, and economic policy.

Demand for a currency arises when individuals, businesses, or governments want to buy that currency to pay for imports, invest abroad, or speculate on currency movements. For example, if UK firms want to import goods from the USA, they need US dollars, increasing the demand for dollars.

An increase in demand for a currency, holding supply constant, causes the currency to appreciate (rise in value). Conversely, a fall in demand leads to depreciation.

• Demand for currency comes from importers, investors, and speculators.
• Higher demand for a currency leads to its appreciation.

Supply of a currency occurs when holders of that currency want to exchange it for another currency. For instance, if US tourists visit the UK, they will supply US dollars to buy British pounds.

An increase in the supply of a currency, with demand unchanged, causes depreciation (a fall in value). A decrease in supply causes appreciation.

• Supply of currency comes from exporters, investors repatriating funds, and speculators.
• Higher supply of a currency leads to its depreciation.

The equilibrium exchange rate is the rate at which the quantity of currency demanded equals the quantity supplied. At this point, the foreign exchange market clears with no excess demand or supply.

If the exchange rate is above equilibrium, excess supply causes the currency to depreciate toward equilibrium. If below, excess demand causes appreciation toward equilibrium.

For example, if the pound is initially £1 = $1.30 but demand for pounds rises, the rate may move to £1 = $1.40, reflecting appreciation of the pound.

• Equilibrium occurs where demand equals supply.
• Exchange rates adjust to eliminate excess demand or supply.
• Market forces drive exchange rates toward equilibrium.

Suppose the demand for Japanese yen increases because UK investors want to buy Japanese assets. This increased demand for yen causes the yen to appreciate against the pound.

Conversely, if Japanese importers need more pounds to buy UK goods, the supply of yen increases, causing the yen to depreciate relative to the pound.

These changes illustrate how shifts in demand and supply curves affect exchange rates.

• Increased demand for a currency causes appreciation.
• Increased supply of a currency causes depreciation.

The demand for a country's exports and imports directly influences its currency value. When foreign buyers increase demand for a country's exports, they need to purchase that country's currency to pay for goods, increasing demand for the currency and causing it to appreciate. Conversely, if domestic consumers increase demand for imports, they sell their own currency to buy foreign currencies, increasing supply of the domestic currency and causing depreciation.

For example, if UK exports of machinery to the EU rise sharply, EU importers must buy more British pounds to pay UK exporters, increasing demand for the pound and pushing its value up. On the other hand, if UK consumers buy more American electronics, they sell pounds to buy US dollars, increasing pound supply and potentially lowering its value.

• Higher export demand increases demand for domestic currency, causing appreciation.
• Higher import demand increases supply of domestic currency, causing depreciation.

Interest rates affect foreign exchange rates by influencing capital flows. Higher interest rates in a country offer better returns on investments denominated in that currency, attracting foreign investors seeking higher yields. This increases demand for the currency, leading to appreciation.

For instance, if the Bank of England raises interest rates while the US Federal Reserve keeps rates steady, investors may move funds into UK assets to gain higher returns. To do so, they buy pounds, increasing its value relative to the dollar. Conversely, lower interest rates can cause capital outflows and currency depreciation.

• Higher interest rates attract foreign capital, increasing currency demand and appreciation.
• Lower interest rates may lead to capital outflows and currency depreciation.

Speculation involves traders buying or selling currencies based on expectations of future exchange rate movements. Speculators aim to profit from anticipated currency appreciation or depreciation, which can cause rapid and sometimes volatile fluctuations in exchange rates.

For example, if speculators expect the euro to strengthen against the dollar due to upcoming economic data, they may buy euros in large volumes. This increased demand can itself cause the euro to appreciate, fulfilling the speculation. However, speculative attacks can also destabilise currencies if confidence suddenly shifts.

Speculative activity can amplify short-term exchange rate movements beyond what fundamentals alone would suggest.

• Speculators trade currencies based on expected future movements.
• Speculation can cause rapid and volatile exchange rate fluctuations.
• Speculative demand can reinforce or trigger currency appreciation or depreciation.

Multinational corporations affect exchange rates through their international business operations, including investment decisions, currency conversions, and repatriation of profits. Large-scale currency transactions by MNCs can influence demand and supply in foreign exchange markets.

For example, if a US-based MNC invests heavily in Europe, it must convert US dollars into euros, increasing demand for euros and potentially causing euro appreciation. Similarly, when MNCs repatriate profits from foreign subsidiaries, they convert foreign currency back into their home currency, affecting exchange rates.

MNCs also hedge currency risk, which can influence currency demand patterns and market expectations.

• MNCs' currency conversions for investment and trade affect currency demand and supply.
• Large transactions by MNCs can cause noticeable exchange rate movements.
• Profit repatriation by MNCs influences currency flows and exchange rates.

A foreign exchange rate is the price of one currency expressed in terms of another. When this rate fluctuates, it changes the relative cost of goods traded internationally.

If the domestic currency appreciates (increases in value relative to foreign currencies), exporters receive more domestic currency for each unit of foreign currency. However, from the perspective of foreign buyers, the price of exports in their own currency rises, making exports more expensive.

Conversely, imports become cheaper in domestic currency terms because fewer units of domestic currency are needed to buy the same amount of foreign currency to pay for imports. This tends to increase imports as domestic consumers find foreign goods more affordable.

• Appreciation raises export prices in foreign currency terms, reducing competitiveness abroad.
• Appreciation lowers import prices in domestic currency, encouraging more imports.
• Depreciation has the opposite effects: exports become cheaper for foreign buyers, imports become more expensive domestically.

Price elasticity of demand measures how sensitive the quantity demanded of a good is to a change in its price. It is calculated as:

PED = (% change in quantity demanded) ÷ (% change in price)

If PED > 1, demand is elastic: quantity demanded changes proportionally more than price changes. If PED < 1, demand is inelastic: quantity demanded changes less than price changes. If PED = 1, demand is unit elastic.

• Elastic demand means consumers respond strongly to price changes.
• Inelastic demand means consumers respond weakly to price changes.
• PED varies between products and markets, affecting trade outcomes after exchange rate changes.

When the domestic currency appreciates, export prices rise in foreign currency terms, which tends to reduce foreign demand for exports. The extent of this reduction depends on the PED of exports.

If export demand is elastic, a price increase causes a large fall in quantity demanded, reducing total export revenue.

If export demand is inelastic, quantity demanded falls little, so total export revenue may increase despite higher prices.

• Appreciation can reduce export volumes if foreign buyers are price sensitive.
• Imports become cheaper domestically, increasing quantity demanded if import demand is elastic.
• If import demand is inelastic, cheaper prices increase spending but quantity demanded changes little.

A depreciation lowers export prices in foreign currency terms, making exports more competitive and likely increasing foreign demand.

If export demand is elastic, the increase in quantity demanded will be proportionally larger than the price drop, increasing total export revenue.

If export demand is inelastic, quantity demanded rises less than the price falls, potentially reducing total export revenue.

• Depreciation tends to boost export volumes and revenues if demand is elastic.
• Imports become more expensive domestically, reducing quantity demanded if import demand is elastic.
• If import demand is inelastic, spending on imports may rise despite higher prices.

Example 1: A UK car exporter faces a 10% appreciation of the pound. If foreign buyers see UK cars as elastic in demand, the 10% price rise in their currency leads to a 15% drop in quantity demanded, reducing total export revenue.

Example 2: A country imports oil, which has inelastic demand. A 20% depreciation raises import prices by 20%, but quantity demanded falls only 5%, so total spending on oil imports increases.

• Elastic goods show large quantity changes, affecting trade balances significantly.
• Inelastic goods show small quantity changes, so spending changes mainly reflect price changes.

Understanding how exchange rate fluctuations affect export and import prices and spending is crucial for governments and firms.

Firms exporting goods with elastic demand must manage exchange rate risks carefully, as price changes strongly affect sales volumes.

Governments monitoring trade balances consider PED to predict how currency movements influence exports and imports, helping to design policies to stabilise the economy.

• Exchange rate changes influence trade flows through price adjustments.
• PED determines the magnitude of quantity and spending changes.
• Effective trade and currency policies require knowledge of PED and exchange rate dynamics.

Exchange rates determine how much one currency is worth in terms of another. Countries manage their exchange rates mainly through two systems: floating and fixed. Understanding these systems is essential because exchange rates influence trade competitiveness, inflation, and economic stability.

• Exchange rate: price of one currency in terms of another.
• Two main systems: floating and fixed exchange rates.

In a floating exchange rate system, the currency's value is set by the foreign exchange market through supply and demand without direct government control. For example, if demand for a country's exports rises, demand for its currency increases, causing appreciation. Conversely, if investors lose confidence, the currency may depreciate.

This system allows automatic adjustment to economic conditions. For instance, if a country faces a trade deficit, its currency may depreciate, making exports cheaper and imports more expensive, helping to correct the deficit over time.

• Currency value determined by market forces.
• Adjusts automatically to economic changes.
• Example: US dollar fluctuates daily against the euro.

Advantages include flexibility and automatic correction of imbalances. Since the government does not intervene, the currency reflects true market conditions, reducing the risk of prolonged overvaluation or undervaluation.

However, floating rates can be highly volatile, causing uncertainty for businesses engaged in international trade. For example, a sudden depreciation can increase import costs, leading to inflation. This volatility can deter foreign investment and complicate economic planning.

• Advantages: automatic adjustment, no need for large reserves.
• Disadvantages: exchange rate volatility, potential inflationary pressures.

A fixed exchange rate system pegs a currency's value to another currency or a basket of currencies. The government or central bank intervenes by buying or selling currencies to maintain the fixed rate. For example, a country might fix its currency at 1 unit = 0.75 US dollars.

This system provides certainty for traders and investors because exchange rates remain stable. However, maintaining the peg requires large foreign currency reserves and can limit a country's ability to use monetary policy independently.

• Currency value set and maintained by government.
• Requires intervention to keep rate stable.
• Example: Hong Kong dollar fixed to US dollar.

Fixed rates offer stability, encouraging international trade and investment by reducing exchange rate risk. They can also help control inflation by anchoring the currency to a stable foreign currency.

On the downside, fixed rates can become misaligned with economic fundamentals, leading to trade imbalances. For example, if a currency is overvalued, exports become expensive, hurting domestic producers. Maintaining the peg can be costly and may lead to currency crises if reserves run low.

• Advantages: exchange rate stability, inflation control.
• Disadvantages: costly to maintain, risk of misalignment and crises.