Exchange Rates

Foreign Exchange Market

Currencies are bought and sold on a foreign exchange market. The demand for a currency is a function of three main variables.

The demand for other countries’

goods and services: When European tourists visit the US they will need US dollars and European citizens wanting more US goods will be met by European importers increasing their demand for US dollars in order to buy US goods.

(These transactions for which EU citizens need dollars correspond to the current account.)

The demand for FDI (foreign direct

investment) and portfolio investment in

another country. Firms setting up subsidiaries abroad will need foreign exchange, and citizens, firms and investment houses in the US wanting to buy shares, bills/bonds or deposit money in European banks will need EUROs. (These transactions for which EU citizens need dollars correspond to the capital account.)

Speculative demand

When international speculators such as fund management firms and other financial institutions believe that the EURO will appreciate, they will buy EUROs in order to make a gain in selling them when the EURO rate rises. (These transactions also involve the capital account.)

Fixed exchange rates

When a group of two or more countries instead keep their exchange rate constant, a fixed exchange rate has been established. (Pegged managed)

Typically, countries in a fixed exchange rates regime use the central bank to intervene on the foreign exchange market in order to keep the exchange rate within a narrow band — much like the mechanism used in a buffer stock scheme.

The central bank can affect the exchange rate in the short run by buying or selling its own currency on the foreign exchange market, and by adjusting the interest rate to influence investors’ demand for the currency.

In the long run, governments might intervene using fiscal policies, supply-side measures and protectionism to adjust national income in order to increase or decrease exports and citizens’ propensity to import.

Changes in exports would affect the demand for the home currency, while a change in imports would affect the supply of the home currency.

FLOATING EXCHANGE RATES

A floating exchange rate is where he value of a currency Is allowed to be determined solely by the demand for, and the supply of, the currency on the foreign exchange market.

There is no governmental intervention in the market.

Demand curve is downward sloping and represents the demand for dollars by people in the EU – or people who hold Euros.

The supply curve is also normal and represent the supply of dollars, which of course comes from the USA.

If the value of the currency rises it is an appreciation of the value of the currency.- If it falls then we say it depreciated.

Supply

Demand

Quantity of US $

1.50

1.00

.80

.50

What causes the value of a currency to

change compared to another currency?

Demand curve

People in the EU will have to buy $ in the foreign exchange market to

Buy US goods and service and travel to the USA

Invest in US firms

Save their money in US banks

Make money speculating on the US dollar.

Demand for $ will rise

there is an increase in the demand for US goods and services. This could be caused by:

US inflation rates being lower than EU inflation rates, making US goods and services relatively less expensive than EU goods and services

an increase in incomes in the EU, so people in the EU increase their demand for all things, including imports from the US

a change in tastes in the EU in favor of US products

investment prospects improve

• US interest rates increase, making it more attractive to save there than in EU financial institutions

• speculators in the EU think the value of the US dollar will rise in the future, so they buy it now. If they are correct, then they will be able to sell those US dollars in the future, when they are worth more, and make a financial gain.

As we can see, an increase in the demand for the US dollar from the EU will shift the demand curve for the US dollar to the right to D1.

When this happens, the value of the dollar will appreciate and it will now be worth 0.90 euros.

Each US dollar may be exchanged for a larger amount of euros.

Supply

Demand

Quantity of US $

1.50

1.00

.80

.50

D1

Supply Curve The US dollar will be supplied on the foreign exchange market when Americans wish to: do the opposite of what happened before

buy EU goods and services and to travel in Europe

invest in EU firms (FDI or portfolio investment)

save their money in EU banks or other financial institutions

make money by speculating on the euro.

etc

As we can see, an increase in the supply of the US dollar on the US dollar/euro market will shift the supply curve of the US dollar to the right to S1.

When this happens, the value of the dollar will depreciate and it will now be worth €0.70.

Each US dollar may be exchanged for a smaller amount of euros.

Supply

Demand

Quantity of US $

1.50

1.00

.80

.50

S 1

Managed Exchange Rates

Completely fixed exchange rates create a problem of inflexibility, since economies will have different fundamentals such as growth rates and inflation rates.

In the long run, it could be very costly for a country with a weakening currency to defend its link to other currencies, for example by running down the foreign reserves and dampening the domestic economy — and thereby reducing imports — by raising interest rates.

For this reason, fixed exchange rate regimes are for the most part not bound in iron; a currency can be readjusted in the long run to better match its fundamental equilibrium.

The most common form is for a country to peg its currency to another-, often the US dollar.

Depreciation and Devaluation

When a currency falls compared to another currency we say the currency has depreciated.

Summer of 2007 US$ depreciated the Euro so it was more expensive for US tourist to travel to Europe , but the Europeans loved the bargains in the USA.

Devaluation

This is when a fixed or pegged currency is realigned by the government to a lower exchange rate.

Usually it is because of a financial crisis and the currency can not match the previous price set against the US$

Appreciation and Revaluation

So the opposite a floating currency increase in value against other floating currencies the currency is said to have appreciated.

A pegged currency can re-peg the currency at a higher rate so 1 USD = 8.1 RMB – hey not any more now it is 1 USD = 6.8 RMB.

Effects on Exchange rate

All the following factors that effect the exchange rate assume that the currency is a floating currency and that ach of the determinants below is operating under the ceteris paribus conditions.

TRADE FLOW

When American exports increase, there will be an increased demand for the dollar as importers in other countries will need more dollars to buy the American goods.

The same goes for services and tourism; more banking services and tourism mean greater demand for the dollar. Increased exports will increase the demand for the dollar

CAPITAL FLOWS/ IINTEREST

RATE CHANGES