Exchange rates

Exchange rate: shows the rate at which one currency can be exchanged for another and can be regarded as the price of one currency in terms of another currency.

• For instance, if £1 = $2, this means that the British have to give £1 to obtain or purchase $2.

• Exchange rates are essential in real life because countries have different currencies, and to make any international trade payments, these rates must be considered.

Digram:

Measurement of Exchange rate:

• Trade Weight index

• Real Exchange rate 

• Effective exchange rate 

• Trade Weight index:

• Real Exchange rate :

• Effective exchange rate :

There are 3 types of systems which determine the value of the exchange rate, and these are:

1. Freely floating / flexible exchange rate system.

2. Fixed exchange rate.

3. Managed flexible / Dirty floating exchange rate system.

Under the floating exchange rate system, the rate of exchange is determined by the market forces of demand and supply of currency.

Thus, the sterling exchange rate is determined by the demand and supply of pounds (£).

The government does not intervene to maintain a particular rate.

• Assume 2 countries, UK and USA.

• The demand for £ constitutes demand for UK exports.

• This is because when US residents wish to purchase UK goods or to invest in UK, they will require £.

• The lower the dollar price of £, the cheaper it will be for them to obtain UK goods, and hence the more £ they are likely to demand.

• Thus, demand curve for £ slopes downwards. On the other hand, the supply of £ represents demand for UK imports.

• This is because when UK importers wish to buy US goods or to invest in US, they will supply £.

• The higher the exchange rate, the more £ will be supplied since imports become cheaper. Hence, the supply curve of £ slopes upwards.

Digram:

• The diagram shows the demand for £, D£D£, and the supply of £, S£S£, on the foreign exchange market.

• The market price or the equilibrium price of the £ is fixed where demand equals supply at anexchange rate of £1 = $1.60.

• Any exchange rate above the equilibrium, for instance at £1 = $1.80, the supply of £ beingoffered to the banks exceeds the demand.

• There would be an excess supply of £. Hence, banks would lower the exchange rate in order to encourage a greater demand for £ and reduce the supply.

• They would continue lowering the rate until demand equalled supply.

• Similarly, if the exchange rate were below the equilibrium, say at £1 = $1.40, there would be a shortage of £.

• Banks would thus raise the exchange rate until demand equalled supply.
• In practice, the process of reaching equilibrium is extremely rapid.

• Under the floating exchange rate system, any changes in the demand and / or supply conditions of the currency will cause the value of the exchange rate to change.

• For instance, an increase in the demand for UK exports implies that foreigners are offering more money so that demand for £ increases.

• Thus, the price of £ is said to have appreciated. This can be illustrated as follows:

Digram:

• 1. Surpluses and deficits in a country’s BOP cease to be a problem.

• 2. The freely floating exchange rate system does not affect the policy measures adopted by the government. 

• 3. Governments would no longer need to hold large reserves of currencies.

• 4. There is no under or over valuation of the exchange rate under this system.

• 5. Inflation usually causes an unfavourable BOP.

1. Surpluses and deficits in a country’s BOP cease to be a problem.

• This is explained by the selfadjusting mechanism of the market forces.

• For instance, if a country has a deficit in its BOP due to increased imports, this will cause depreciation in its currency.

• As a result, the country’s exports will be cheaper, thus increasing the demand for its exports.

• On the other hand, imports will become less competitive.

• Eventually, the BOP will be brought back into equilibrium.

• Conversely, a BOP surplus will be eliminated by an appreciation of the currency.

2. The freely floating exchange rate system does not affect the policy measures adopted by the government.

• Proponents of flexible rates have claimed that governments could concentrate their policies on the domestic problems of inflation and unemployment,

•  leaving automatic exchange rate changes to deal with any external imbalances.

3. Governments would no longer need to hold large reserves of currencies.

If monetary authorities were not intervening in the foreign exchange market to stabilise rates, reserves would be unnecessary.

4. There is no under or over valuation of the exchange rate under this system.

• In addition, the freely floating system allows for subsequent changes in demand and supply conditions of the currency reflecting changes in international trade.

• Thus, this system encourages an efficient allocation of resources without distorting exchange rate.

5. Inflation usually causes an unfavourable BOP.

But under this system, inflation leads to a subsequent depreciation of the country’s currency which will again create a higher demand for exports and a lower demand for imports, thereby eliminating the deficits.

• 1. Uncertainty:
• 2. Speculation:
• 3. It may be inflationary for deficit countries

1. Uncertainty:

• The fact that currencies change in value from day-to-day due to changing demand and supply conditions for exports and imports introduces a large element of uncertainty.

• Businessmen and customers become doubtful about prices of goods.

• These uncertainties may affect adversely the volume of foreign transactions.

• Importers and exporters may be discouraged from trading because of the “exchange rate risk”.

• Besides, the uncertainty may discourage foreign investment.

2. Speculation:

• Speculation may occur because certain individuals, being eager to maximise capital gains, will deal with the sales and purchase of currencies in great quantities. 

• This will distort the equilibrium exchange rate. 

• For instance, if speculators think that the exchange rate will fall, then they will sell the currency, and this will cause the exchange rate to fall even further.

3. It may be inflationary for deficit countries:

• A country with a persistent deficit will experience a depreciating currency.

• As noted, such a depreciation will raise the price of imports and, at the same time, increase the demand for country’s exports and imports- substitutes.

• It may, therefore, exert both cost-push and demand-pull inflationary pressure on the domestic economy.