EXCHANGE

RATES

International transactions
involve the use of different
national currencies, known
as foreign exchange
FOREX is not a centralized
meeting place, but involves
any location where one
EXCHAN
currency can be exchanged
for another
GE RATES Exchange rates – are the
value of one currency
expressed in terms of
another currency
The rate at which they are
exchanged is referred to as
that currency’s exchange
rate
These currencies are traded
for each other in the foreign
exchange market (FOREX) by
individuals, firms, banks,
other financial institutions
or the govt.
Ex. Resident of Russia going
to Denmark – you must
exchange your rubles for
Danish kroner (Denmark
residents want to be paid in
Kroners not rubles)
Currencies of different
economies have different
values, therefore they are
not exchanged at parity
(one-for-one basis)
The value of a currency is
always measured in terms of
another currency or basket
of other currencies
• Rubles to Kroner example:
• You change your rubles into Danish Kroner,
so you are DEMANDING Danish Kroner –
You are SUPPLYING Russian Rubles in the
FOREX
• Suppose United Kingdom and Japan want
to trade with each other:
• When Japan import from the UK, they buy
and DEMAND British pounds in the FOREX
to pay for the UK exports – to receive
pounds, they sell or SUPPLY Japanese Yen
in the FOREX
• When UK imports form Japan, they
DEMAND Yen and SUPPLY pounds in the
FOREX
• Demand for a foreign currency generates a
supply of domestic currency; and demand
for the domestic currency generates a
supply of foreign currencies
• Demand for pounds ↔ supply of Yen
Demand for Yen ↔ supply of pounds
 EXCHANGE RATES
the value of one currency in terms of another
• Ex. Number of dollars per Euro $/€ 1.5 dollars = 1 Euro (price of Euro in terms of dollars)
This expression gives the “value” or “price” of 1 euro in terms of dollars or how many dollars must be given up
to buy 1 euro as well as how many dollars can be gotten if 1 euro is given up
Number of euros per dollar €/$ 0.67 euros = 1 dollar (price of dollar in terms of euros)
This expression gives the “value” or “price” of 1 dollar in terms of euros or showing how many euros must be
given up to buy 1 dollar as well as how many euros can be gotten in exchange for one dollar
FLOATING EXCHANGE RATE
(flexible exchange rate system)

• Exchange rates are determined by market forces

(supply and demand) with no govt. or central bank
intervention in the FOREX
• Vertical axis – price of dollars in terms of euros
• Horizontal axis – quantity of dollars
• Demand curve shows demand for dollars
• Downward sloping - eurozone residents who need
dollars to carry out transactions in the US and to
pay for imported goods and who want to invest in
the US will demand less dollars since the price of
dollars in terms of euros increases or they will
demand more if the opposite occurs – (.80 euros
needed to buy 1 dollar – euro zone residents buy
fewer dollars than if it only cost .50 euro to buy 1
dollar
• Upward-sloping supply curve is from
US residents who like to sell dollars to
buy euros
• US residents who want to import
goods from the Euro zone or take a
holiday, or invest in a Euro zone
country need Euros
• If price of dollars is .5 Euros per dollar
– U.S. residents need to supply 1
dollar to buy .5 Euro worth of euro
zone goods – if the price of dollars
increases to .8 euro worth of euro
zone goods we see that as the price of
dollars goes up, euro zone goods
become cheaper and so more dollars
are supplied
• As the price of dollars in terms of
euros increases, the quantity of
dollars supplied increases
• The intersection of the demand and supply curves determines the equilibrium
“price” of the dollar in terms of the Euro – the equilibrium exchange rate, which is .67
euros per dollar
• Higher than equilibrium, such as at .8 euro per dollar there would be an excess
supply of dollars
• Lower than equilibrium, such as at .50 euro per dollar, there would be excess demand
for dollars
• Market for euros is equivalent: 1 dollar for .67 euros is the same as 1 euro for 1.50
dollars (1/.67 = 1.50 or 1/1.50 = .67)
 APPRECIATION
• An increase in the value of a currency in a floating exchange rate
system
 DEPRECIATION
• A fall in the value of a currency in a floating exchange rate system
DETERMINANTS OF
EXCHANGE RATES
1. EXPORTS AND FACTORS AFFECTING EXPORTS
A. Foreign Demand for exports of goods - ↑ in
foreigners’ demand for goods, ↑ in demand for
the currency (foreigners’ demand for Swill
watches increases, so demand for Swiss Franc
increases) – Franc appreciates – vice versa
B. Foreign Demand for exports of services – same
as above (increase in Tourism from abroad leads
to an increase in export of tourism services –
tourists demand more of the country’s currency
and currency appreciates) – vice versa
This Photo by Unknown Author is licensed under CC BY-NC-ND
C. The rate of inflation relative to other countries – If
Sweden experiences a lower rate of inflation than
other countries, demand for its exports ↑ and demand
for the Swedish Krona ↑ - currency appreciates – vice
versa
D. Relative Growth Rates – If Kenya’s trading partners
experience a high growth rate, this means their
incomes are rising and they demand more exports
from Kenya – demand for Kenya shilling increases –
shilling appreciates – vice versa
2. INVESTMENT AND FACTORS
AFFECTING INVESTMENT
A. Inward foreign direct investment
(FDI) and portfolio investment –
There are two types of investment by
foreigners:
- Foreign direct investment (investment
by multinational corporations in
productive facilities)
- Portfolio investment (financial
investments, such as purchase of stocks
and bonds)
Both impact ER the same:
If investment is inward (coming into the
country), foreigners are bring in funds
from abroad by demanding domestic
currency (if foreigners want to increase
their investments in China, they must buy
Yuan – demand for Yuan increases – Yuan
currency appreciates – vice versa
B. Relative Interest Rates – financial
capital refers to funds that are used
to make financial investments, or
investments that receive a return
based on interest rates – financial
capital is a form of portfolio
investment
(ex. Savings deposits in banks, purchases
of bonds) – the higher the interest rate,
the more attractive these investments will
be – If interest rates are high in the UK
relative to other countries, financial
investment become more attractive –
demand for British pound increases –
pound appreciates

This Photo by Unknown Author is licensed under CC BY-SA

3. OTHER FACTORS AFFECTING CURRENCY DEMAND
A. Inward flow of remittances (involve a transfer of money
from one country to another, in most cases by foreign
workers who send money from their earnings in the
country of residence to their family in their home
country)
-in 2018 China and India were the largest receivers of
remittances of their workers abroad who sent money home
Increase in Indian Rupee when the money comes in from
abroad – rupee appreciation
B. Speculation (involves buying and selling currencies to
make a profit from changes in exchange rates)
-if currency is expected to appreciate, they buy it in hopes of
selling it after it appreciates – just the buying alone can cause
currency to appreciate
C. Central bank intervention to increase the value of a
currency –
Every central bank holds foreign currency in reserves – they
use these reserves to buy and sell to influence the value of
the domestic currency – if the FED wants to ↑value of
domestic currency, it demands (buys) domestic currency (by
selling foreign currencies), US dollar demand increases –
dollar appreciates
3.2 Exchange Rates Effects of Appreciation and Depreciation

Economic Effects of Appreciation and Depreciation

The table below outlines the likely effects on domestic macroeconomic conditions and on a
nation’s external balance of payments of both an appreciation and a depreciation of its currency
Unemployment Balance of
Inflation rate Economic Growth rate payments

Unemployment could rise The current account should

Inflation will be lower, Growth will likely slow, if net exports decline. Also, move into deficit (since Xn
As a result of since imported goods since a stronger domestic firms may choose will fall) and the financial
and services and raw currency will reduce net to move production account towards surplus,
appreciation materials are now exports, a components overseas, where costs are as financial and real assets
cheaper of AD now lower due to strong become more attractive to
currency foreign investors

Growth should increase, Unemployment should fall The current account should
Inflation will increase,
since the country’s as net exports increase, move towards surplus
since imports are more shifting AD out. Domestic (since Xn will increase) and
As a result of exports are cheaper and
expensive, and there firms may choose to the financial account
more attractive to
depreciation could be cost-push
foreigners. AD will
relocate some of their
overseas production to the
towards deficit, as financial
and real assets become
inflation if raw material
increase, leading to now cheaper domestic less attractive to foreign
costs rise for producers market investors.
short-run growth
 EVALUATION OF EXCHANGE RATES –
cont.
Effects on Foreign Debt
• A depreciation of a currency causes the value of foreign debt to
increase
• Ex. – Mountainland owes foreigners $1000, and the exchange rate is
Mnl 1.5 = $1
• Its foreign debt is therefore Mnl 1500 – if Mnl depreciates so that now
Mnl 2 = $1 – mountainland’s foreign debt of $1000 becomes Mnl of
2000
• Many developing countries face this problem
• A currency appreciation causes the value of foreign debt to fall
FIXED
EXCHANGE
RATES
• Fixed by the central bank of each country
at a particular level (or narrow range)
• ER is still determined by currency supply
and demand - BUT they are manipulated
by the Central Bank or Govt. to arrive at a
certain equilibrium
• The CB buys and sells reserve currencies
and makes other adjustments to the
economy in order to shift demand and
supply
 INTERVENTION TO MAINTAIN FIXED
EXCHANGE RATES
1. USING OFFICIAL RESERVES TO MAINTAIN THE EXCHANGE RATE –
• Ex. Excess supply of boples from Bopland so CB of Bopland can buy up
excess boples by selling some of their foreign currency reserves
$/B So, if demand for Bopland’s exports fell and demand for
boples decreased, in a free floating ER system the Bople
would depreciate

BUT in a fixed exchange rate system, at $2.00 there would be

$2.00 an excess supply of Boples – could run out of reserves and
have to use other methods
$1.50
So. The CB of Bopland can take their reserves of $ and buy up
the excess supply of Boples causing demand to return back to
original ER of $2.00 = 1 Boples

If there had been excess demand of Boples then the CB

Q of Boples
would dump (sell Boples) to buy dollars
2. Increase in
Interest Rates
• A CB can implement
contractionary monetary policy
or expansionary monetary policy
to manipulate interest rates
• High interest rates lead to
currency appreciation
• Low interest rates lead to
currency depreciation
3. Borrowing
from abroad
• If a country borrows form
abroad, its loans will come in the
form of foreign exchange, which
when converted into Boples will
cause an increase in the demand
form Boples
4. Efforts to limit
Imports
• The govt. could limit imports because
limiting imports reduces the supply of
domestic currency in the Forex since it
reduces demand for foreign currency
• Govt. could use contractionary fiscal and
monetary policies to lower aggregate
demand, lower incomes, and result in
fewer imports – could cause recession
• Govt. could implement protectionist
policies – comes with all the disadvantages
$/B So, If there is fall in demand for Bopland’s exports and
demand for Bolples fall – currency depreciates

Govt could limit imports therefore reducing supply of

Boples (no dumping of Boples to buy foreign goods) – ER
back to original – supply shifts left because boples are
wanted over foreign currency now

Q of
Boples
• Devaluation – if the currency value is higher than what can be
maintained through intervention, the govt. may change it to a
new, lower value called devaluation

• Revaluation – if the currency has a lower value than can be

maintained by intervention, the govt. may set a new higher
value called revaluation

• Ex. 2USD = 1 British pound - dollar devalues and new fixed rate
is 3 USD = 1 British pound
• Because dollar lost some of its value – a revaluation of the
pound relative to the dollar occurred
• “gold standard was an example of fixed ER – countries fixed
their ER relative to the value of gold

This Photo by Unknown Author is licensed under CC BY-SA

MANAGED
EXCHANGE RATES
• In between floating and fixed ER
• Also known as “managed float”
• ERs are allowed to float, but at time the CB
intervenes to stabilize them over the short term
• Objective of CB is to prevent large fluctuations in
ERs
• Usually interventions are done through the
buying and selling of currencies, changing
interest rates, contractionary policies and
protectionist policies when currency is
experiencing downward pressure
PEGGING
EXCHANGE RATES
• A number of countries peg (fix) their currencies to
the US dollar, and float together with it and some
with the Euro
• The pegged currency is allowed to fluctuate only
within a narrow range above and below a target
exchange rate relative to the dollar or Euro – if the
actual exchange rate hits the upper or lower limit
of the range, the CB intervenes to keep it within
the limits
• Countries that peg to the USD experience ER
stability and that facilitates trade flows with the US
and other countries that also peg their currency to
the USD
• Strong financial centers such as Hong Kong peg
their currency to the USD
 CONSEQUENCES OF
OVERVALUED AND
UNDERVALUED
•
CURRENCIES
Overvalued currency – has a value that is too high
relative to its equilibrium free market value
• Undervalued currency – has a value too low relative to its
equilibrium free market value
• OVERVALUED CURRENCIES:
• Most developed countries have at times overvalued ERs
• imports become cheaper (capital goods and raw
materials for use in manufacturing industries)
• Exports become expensive
• Worsening current account balance
• Hurts domestic producers when imports are cheaper and
employment
• Resource misallocation

This Photo by Unknown Author is licensed under CC BY

• UNDERVALUED CURRENCIES:
• Exports become less expensive to
foreign buyers
• Imports become more expensive
• Increased employment
• Creates an unfair competitive
advantage compared to other
countries – considered “cheating” or a
“dirty float”
• Can lead to cost-push inflation
• Ecuador – look up currency
• Bahamian dollar – look up currency