exchange rates

• Exchange rate


  The price of one currency in terms of another
• Floating exchange rate


  • A system whereby the price of one currency in terms of another is determined by the forces of demand and supply
• Fixed exchange rate


  • A system whereby the price of one currency in terms of another is set at a specific rate and this rate is maintained by the government/central bank/monetary authority
• Managed exchange rate (or semi-fixed or dirty float)


  • A system whereby the exchange rate is allowed to float freely within a permitted band. Intervention only occurs when the exchange rate reaches the upper or lower limits
• Factors that affect the supply curve

  • Those in the domestic country wishing to import goods and services
  • Domestic multinational firms wishing to set up in other countries
  • Domestic firms and individuals wishing to buy shares and other financial assets in other countries
  • Firms speculating on the international money markets
  • Governments selling their reserves of the currency
• Factors that affect the demand curve

  • Those individuals and organisations in foreign countries wishing to buy domestic exports of goods and services
  • Foreign multinational firms wishing to set up domestically
  • Foreign firms and individuals wishing to buy shares and other financial assets in the domestic country
  • Firms speculating on the international money markets
  • Governments selling their reserves of the currency (hence, buying other currencies)
• Appreciation

  An upward movement of the exchange rate
• Impact of an Appreciation

  Exports will be more expensive, imports will be cheaper, net exports (X-M) will fall which should increase the current account deficit, cost push inflation may be reduced
• Depreciation


  A downward movement of the exchange rate
• Impact of a Depreciation

  Exports will be cheaper, imports will be more expensive, net exports (X-M) will rise which should reduce the current account deficit, cost push inflation may occur
• Floating exchange rate


  • a system whereby the price of one currency in terms of another is determined by the forces of demand and supply
• Fixed exchange rate


  • a system whereby the price of one currency in terms of another is set at a specific rate and this rate is maintained by the government/central bank/monetary authority.
• Managed exchange rate


  • The government will intervene to buy and sell currency if the exchange rate goes above the upper limit or below the lower limit of the permitted band
• Changes in interest rates


  Can cause changes to the exchange rate through financial flows known as 'hot money'
• An increase in the interest rate (above other countries)

  Inflow of 'hot' money into the country's banks and financial institutions, increasing the demand for the currency and causing an appreciation of the exchange rate
• A decrease in the interest rate (below other countries)


  Outflow of 'hot' money from the country's banks and financial institutions, decreasing the demand for the currency and causing a depreciation of the exchange rate
• How exchange rate is determined

  In a market (interaction of demand and supply), where demand and supply intersect
• Appreciation


  Rise in the value of a currency
• Depreciation


  A fall in the value of a currency
• Balance of trade

  X - M, where trade surplus is X>M and trade deficit is M>X
• Expectation of increase in interest rates and uncertain US trade policy

  Appreciation of exchange rate
• Uncertainty caused by Brexit

  Depreciation of exchange rate
• Weak Eurozone growth - investment funds leaving the Eurozone countries


  Depreciation of Euro exchange rate
• Western sanctions (reduces demand for Russian goods) and lower oil prices


  Depreciation of Rouble exchange rate
• Announcements that the Fed intends to raise interest rates three more times over the year

  Appreciation of US dollar exchange rate
• Agreement of a Brexit deal reducing uncertainty

  Appreciation of Pound exchange rate
• Uncertainty caused by reckless budget, investors don't want to hold Pound

  Depreciation of Pound exchange rate
• A fall in the value of the Pound means a depreciation, e.g. £1 = $2 to £1 = $1
• As foreigners get more Pounds for their dollars, UK exports become cheaper and demand for them rises, increasing the value of total exports
• As UK firms and citizens get fewer dollars for their Pounds, imports become more expensive and demand for them falls, decreasing the value of total imports
• As a result, net exports/trade balance/X-M should improve (lower deficit, higher surplus or move from deficit to surplus)
• However, a depreciation may not improve the deficit if the fall in the value of the Pound is small, imports are inelastic, or UK exports are of lower quality
• The trade balance (or balance of trade) is X - M, i.e. the value of total exports minus the value of total imports over a time period
• How exchange rates are determined

  Like any price the exchange rate (r/e) is determined by the interaction of the demand and supply of the currency.

  The r/e of a currency is the equilibrium price and occurs where: Qd = Qs.

  The exchange rate will change if either the demand or supply of the currency changes (a shift of the D and/or S curves).

  
• IMPACT OF APPRECIATION

  
• IMPACT OF DEPRECIATION

  
• Fixed exchange rate example

  If the government ‘fixes’ the r/e, the government has to intervene to buy or sell currency when demand or supply changes.

  1. In this example, the fixed rate is r (i.e. $2 = £1)

  2. There is an increase in demand for the currency – which would push the r/e up to r2 if it was a floating rate.

  3. To prevent this, the government will sell pound sterling and buy foreign currency

  4.This increases the supply of £ sterling to S2 and keeps the r/e at r.

  
• to operate a fixed exchange rate, the government needs reserves of major currencies (“currency reserves”). This is the key problem with a fixed r/e system: the government has to keep buying/selling their currency and it is hard to maintain this as reserves eventually run out.
• Hot money

  money that flows regularly between different country’s financial markets as wealth management organisations attempt to ensure they get the highest rate of return (interest rates) possible. 
• Interest rate


  the cost of borrowing and the reward for saving.