Exchange Rate

• Foreign Exchange Rate - the value of one country’s currency compared to another country’s currency

  • Fixed Exchange Rate - value of one currency is fixed or does not change compared to another, set and maintained by central banks
• Floating Exchange Rate - value of a currency is determined by market forces
• Appreciation - a rise in the value of one currency compared to another currency

  • Due to lower supply or increase demand
• Depreciation - a fall in the value of one currency compared to another currency

  • Due to increase supply or decrease demand
• Revaluation - rise in the value of a fixed exchange rate

  • Raise interest rates
  • Decrease Supply
• Devaluation - fall in the value of a fixed exchange rate

  • Lower interest rate
  • Increase Supply
• Factors that impact Exchange Rates (effect the demand for a currency)

  • Changes in exports/imports (balance of payments)
  • Direct foreign investment
  • Actions of Central Banks
  • Economic Speculation
• Current Accounts Surplus - more exports than imports

  • Increase in exports usually equals and increase in demand for a currency causing an increase in the value of the currency
• Foreign investment from Multinational Companies (MNC) - leads to an increase in demand for a currency which should equal an increase in the currencies value
• Actions of Central Banks

  • Increase Interest Rates - usually causes increase in demand based on higher returns by holding the currency
  • Attracting hot money flows
  • Central Banks buying a currency - creates an artificial increase in demand = increase value of currency being bought
• Speculation - investors buying foreign currencies when they anticipate the value of the currency will increase

  • Hot Money Flows - movement of money around the world to take advantage of differences in interest rates and exchange rates.
• Increase in currency value = increase in price of goods exported and a decrease in the price of goods imported
• Decrease in currency value:

  • Increase aggregate demand as exports are cheaper
  • May cause inflation as imports are more expensive
• Balance of Payments - summarises the economic transactions of an economy with the rest of the world.

  • Consist of current account and capital/financial account
• Current Accounts Deficit - country is spending more than it is earning
• Current Accounts Surplus - country is earning more than it is spending
• Current Account Balance - shows the income received by a country compared to its expenditures with other countries
• 4 components of Current Account

  • Trade in Goods
  • Trade in Services
  • Primary Income
  • Secondary Income
• Trade of goods and services has biggest impact on current account balance
• Trade Surplus - revenue from exported goods/services exceeds expense of imported goods/services
• Trade Deficit - expenditure on imported goods/service exceeds revenue from exported goods/services
• Primary Income - includes income earned by individuals and firms

  • Earnings of residents working abroad minus earnings of foreigners working in home economy
  • Profits and investment incomes of firms that come in and go out of the economy
• Secondary Income - net balance of transfers into and out of economy

  • Gifts, charitable donations, workers remittances (money sent to family in other countries)
• Causes of Current Account Surplus

  • Low Exchange Rate (Exports are cheaper than imports)
  • Efficient Production (low cost and high quality)
  • Low Inflation (domestic goods are cheaper than imports)
• Impacts of Current Account Surplus - more money coming into the economy

  • Increase Aggregate Demand
  • Rise in Real GDP
  • Lower Unemployment
  • Demand-pull inflation
  • Appreciation of Exchange Rate
• Causes of Current Account Deficit

  • High Exchange Rate (Exports more expensive)
  • Production Problems (cost and quality)
  • High Inflation (domestic goods more expensive than imports)
• Impacts of Current Account Deficit - More consuming of goods and services than are being producing

  • Decrease Aggregate Demand
  • May Reduce Inflationary Pressure
  • Low Output (Production)
  • Higher Unemployment
• Policies to Reduce a Current Account Deficit

  • Subsidise Exports / lower production cost
  • Restrict imports (tariffs, quotas)
  • Lower exchange rate
• Policies to Reduce a Current Account Surplus

  • Increase Exchange Rate
  • Encourage purchasing of Imports (fiscal policy - lower taxes)