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TRADE
CURRENCY EXCHANGE RATE
CURRENCY EXCHANGE RATE

What is a currency exchange rate?

An 'exchange rate' for currency refers to

the rate at which one currency will be
exchanged for another

For example, if you are holding Australian dollars (AUD)

and wish to exchange them for Sri Lankan rupees (LKR),
the exchange rate on a particular day might be 1AUD =
122 LKR.
CURRENCY EXCHANGE RATE

Most exchange rates are 'floating', which

means they change according to demand
and supply of the currency.

A small number of countries 'fix'

their exchange rates so that the value
is set at a fixed amount relative to a
common currency, often the US
dollar
 A currency exchange
Floating rate that changes
according to supply and
exchange demand, without
government intervention
rate in the currency market.
Types of ER
Fixed A currency exchange
rate that is fixed at a
exchange particular rate through
rate government intervention.
HOW ARE FLOATING EXCHANGE RATES DETERMINED?

Because ER is a price, it is analysed in the same way as the prices of goods i.e. by analyzing the forces of
demand and supply. The only difference the ER is a price that is expressed in relation to another currency.
• Equilibrium ER determined by the intersection between the
dd curve & the SS curve.
Price of 1 A$ in US$ • Dd curve is downward sloping – inverse r/ship between P of
A$ (ER) & qty demanded for A$. Dd for A$ comes from
D S American individuals, corporation & govt that want to buy
Aus assets.
• SS curve is upward sloping – direct r/ship between P of A$
0.8
(ER) & qty supplied for A$. SS of A$ comes from Aus
0.7 individuals, corporations & govt that want to buy American M
& assets.
S D
Qty of A$
300
(millions per day)
Equi ER A$1.00 = US$ 0.8 & equi qty is $300 million per day.

An Aus X of A$100 will cost Americans US$80.

If the ER falls A$1 to US$ 0.7 it will now cost US$70 - causing DD for Aus X to increase leading
to an increase in Qd for A$ and a movement down Dd curve.

If P of A$ falls, Aus M becomes more expensive. Initially US$100 goods will cause Aus A$125
(100/0.8). when ER falls it will cause A$142.86. this causes DD for M by Aus to fall leading to a
fall in Qs of A$ - movement down SS curve.
WHAT CAUSES CHANGES TO DEMAND AND
SUPPLY OF CURRENCY?

Any factor that causes a change in demand and/or supply

of a currency will lead to a change in the equilibrium
exchange rate for that currency. The market for Malaysian
ringgit, this time expressed in terms of the US dollar
(US$)

The value of a currency is always expressed in terms of

another currency. In this case, Figure 2 shows that one
Malaysian Ringgit is valued at $0.23 US, or 23 US cents. A
person would need 23 cents to buy 1 ringgit; or 1 ringgit to
buy 23 cents.
THERE ARE MANY FACTORS THAT MAY CAUSE CHANGES
TO DEMAND AND SUPPLY OF A CURRENCY.

Demand for a Country’s export

People often need to exchange their money if they plan on

visiting another country, or if they wish to purchase goods from
another country. The more of a country's exports that are
demanded, the more that country's currency is also demanded.
So if US consumers demand more of Malaysia's exports, we can
expect demand for the Malaysian ringgit to increase. This will
cause the value of the Malaysian ringgit to appreciate, relative
to the US dollar
THERE ARE MANY FACTORS THAT MAY CAUSE CHANGES
TO DEMAND AND SUPPLY OF A CURRENCY

A Country’s demand for Imports

If Malaysians demand more products from other countries.

They will demand other currencies and thus supply more
Malaysian ringgit in exchange. This will cause a depreciation of
the ringgit.
THERE ARE MANY FACTORS THAT MAY CAUSE
CHANGES TO DEMAND AND SUPPLY OF A CURRENCY
Relative Interest Rates

People also demand currency in order to buy financial assets such as bonds, which provide a return like an
interest rate. We know that if interest rates in a country are higher, there will be more demand for that
country's bonds - people like to earn higher interest rates from the money they invest.

Imagine the US central bank, the Federal Reserve Bank increased its interest rate to 4% while Malaysia's
central bank, the Bank Negara, decreased theirs to 2%. Since central bank rates are expected to influence the
return available from financial investments, we would expect more people, including Malaysians to want to
buy US bonds. We would expect less people, including US people, to want to buy Malaysian bonds since the
US bonds are now more attractive, offering a higher interest rate.
Therefore we would expect demand for Malaysian ringgit to decrease, as less people want to buy Malaysian
bonds, but also the supply of Malaysian ringgit to increase, as Malaysians want to exchange their currency
for US dollars, in order to buy the US bonds.
The changes in demand and supply both work to cause a depreciation of the Malaysian currency
Relative Interest Rates
THERE ARE MANY FACTORS THAT MAY CAUSE CHANGES
TO DEMAND AND SUPPLY OF A CURRENCY

Relative Price Levels

Price levels in a country compared to abroad will influence demand

for exports compared to buying locally-produced products. For
example, imagine the US experiences a high rate of inflation and
prices become relatively much higher than prices in Malaysia. We
would expect a decrease in demand for US products as consumers
in both US and Malaysia prefer Malaysian products with relatively
lower prices. In our currency market, this translates to an increase
in demand for the Malaysian ringgit, since people demand more of
Malaysia's currency to by its products. We would also expect that
less Malaysians will want to exchange their money for US dollars,
as they will demand less US products and will instead buy locally
in Malaysia. This means supply of the ringgit will decrease. An
increase in demand and a decrease in supply in this market leads to
an appreciation of the Malaysian ringgit
THERE ARE MANY FACTORS THAT MAY CAUSE
CHANGES TO DEMAND AND SUPPLY OF A CURRENCY
Relative incomes

Relative incomes in various countries can also impact exchange rates, as they impact the level
of spending each country will be making on imports.

If Malaysian incomes grow faster, relative to US incomes (as measured by real GDP in each
country), we would expect an increase in demand for US products, as Malaysians are likely to
be spending more generally. We would expect a smaller increase in US demand for Malaysian
products, as they would not increase total spending by quite as much. So in our currency
market, this translates to an increase in supply of Malaysian ringgits, as Malaysians seek to
exchange their currency for US dollars so they can buy more US products. Of course they'd
likely be spending more locally too!
If US incomes have also increased, but by a much smaller amount than incomes in Malaysia,
we might see an increase in demand for Malaysian ringgit as US consumers buy more
Malaysian products. But if this is a smaller change, the overall impact on the exchange rate will
be an depreciation of the ringgit
THERE ARE MANY FACTORS THAT MAY CAUSE CHANGES
TO DEMAND AND SUPPLY OF A CURRENCY

Relative incomes
 HOW DO CHANGES IN CURRENCY VALUES
AFFECT THE ECONOMY?
• A depreciation in currency means a country's exports become more
competitively priced.
Effects on net • Exporting firms will benefit from a lower-valued currency (since their product is
exports now relatively cheaper for foreigners), and will produce and sell more
• Depreciation of a currency also leads to imports becoming relatively more expensive.
• a lower-valued currency can benefit the economy by leading to higher GDP through
more net exports. An appreciation of the currency will have the opposite effect.

• When currency depreciates, this means imports become more expensive.

• his includes not only finished goods and services for consumption, but imports
of resources to use in the production process
Effects on • Hence, firms who produce using foreign inputs will find they have higher costs of
costs of production when the currency depreciates.
• Hence, firms who produce using foreign inputs will find they have higher costs of
production production when the currency depreciates.
• If widespread, higher costs of inputs may also lead to inflation within the economy.
An appreciation of the currency can have the opposite effect