🌍 International Trade & Globalisation: Foreign Exchange Rates

Hello Economists! Welcome to one of the most practical and exciting topics in IGCSE Economics: Foreign Exchange Rates.
Why is this important? Whether you buy a smartphone made overseas, plan a holiday abroad, or look at how much your country sells to others, the exchange rate affects everything! It connects the economy in your country to the rest of the world.
Don't worry if this seems tricky at first—we will break down these global connections using simple demand and supply ideas.

What is a Foreign Exchange Rate? (6.3.1)

The Foreign Exchange Rate (often just called the exchange rate) is the price of one currency expressed in terms of another currency.

  • It tells you how much your money is worth when you travel or trade internationally.

Example: If the exchange rate is $1 = €0.90, it means one US Dollar can buy 0.90 Euros.

The Foreign Exchange Market (Forex)

This is the global market where different currencies are bought and sold. It operates 24 hours a day and is essential for facilitating international transactions, such as trade and investment.

How are Exchange Rates Determined? The Floating System (6.3.2)

In most major economies, exchange rates are determined by the forces of Demand and Supply in the foreign exchange market. This is known as a Floating Exchange Rate System (6.3.5).

1. The Demand for a Currency (e.g., demanding US Dollars)

People or countries demand (want to buy) US Dollars when they need to pay for something denominated in Dollars.

  • Demand for US Dollars increases when:
    • Foreign buyers want to buy US exports (goods/services made in the USA).
    • Foreign tourists want to travel to the USA.
    • Foreign investors want to invest in the USA (e.g., buying US company shares or bonds).
    • Speculators believe the value of the US Dollar will rise in the future.
2. The Supply of a Currency (e.g., supplying US Dollars)

The supply of US Dollars comes from people selling their Dollars in order to buy a foreign currency.

  • Supply of US Dollars increases when:
    • US residents want to buy imports (goods/services made abroad).
    • US tourists want to travel overseas.
    • US investors want to invest in foreign countries.
    • Speculators believe the value of the US Dollar will fall in the future.
The Equilibrium Exchange Rate

Just like in a normal market for goods, the equilibrium exchange rate is found where the quantity of the currency demanded equals the quantity supplied.

Quick Review Box: The Market Mechanism

If Demand for the Dollar > Supply of the Dollar, the Dollar price (exchange rate) will rise (Appreciation).
If Supply of the Dollar > Demand for the Dollar, the Dollar price (exchange rate) will fall (Depreciation).

Fluctuations in Floating Exchange Rates (6.3.3)

When the exchange rate changes, we use specific terminology:

  • Appreciation: When the value of a currency rises against another currency (it can buy more of the foreign currency).
  • Depreciation: When the value of a currency falls against another currency (it can buy less of the foreign currency).

Example: If the rate changes from $1 = €0.90 to $1 = €1.10, the Dollar has appreciated (it is stronger).

Causes of Foreign Exchange Rate Fluctuations (Shifts in D & S)

Any event that causes a significant shift in the international demand or supply of a currency will change its value.

1. Changes in Demand for Exports and Imports

  • Increased Demand for US Exports: If UK consumers start buying more American cars, the UK residents need more Dollars to pay the US firms. The demand for Dollars shifts right, causing Appreciation of the Dollar.
  • Increased Demand for US Imports: If US consumers start buying more French wine, US residents sell Dollars to buy Euros. The supply of Dollars shifts right, causing Depreciation of the Dollar.

2. Changes in the Rate of Interest

  • If the Central Bank of Country A increases interest rates, holding money in Country A becomes more attractive for foreign investors (they earn higher returns).
  • This attracts a large flow of financial capital into Country A, increasing the demand for Country A’s currency, leading to Appreciation.

3. Speculation

  • Speculation means buying or selling currency in the hope of making a profit from future price changes.
  • If speculators believe the Euro is about to rise, they buy large amounts of Euros now. This sudden increase in demand causes the Euro to Appreciate immediately.
  • If speculators believe the Euro will fall, they sell it off, increasing supply and causing Depreciation.

4. Entry or Departure of Multinational Companies (MNCs)

  • When an MNC enters a country (e.g., a Japanese car company builds a factory in Mexico), they must convert Yen into Mexican Pesos to pay for land, labour, and construction. This increases the demand for Pesos, causing Appreciation.
  • The departure of an MNC has the opposite effect.

Consequences of Foreign Exchange Rate Fluctuations (6.3.4)

Exchange rate movements significantly impact trade prices, which in turn affect the volume of trade and national income.

The Effects of Appreciation (The currency gets stronger)

1. Exports become more expensive:

  • If the Euro appreciates, US buyers need more Dollars to buy the same €100 item.
  • This usually leads to a fall in the quantity of exports demanded.

2. Imports become cheaper:

  • If the Euro appreciates, Eurozone buyers need fewer Euros to buy the same $100 item.
  • This usually leads to a rise in the quantity of imports demanded.

Overall consequence: Appreciation tends to harm domestic firms that export (exports fall) and encourages imports. This can worsen the country's Balance of Payments (specifically the trade balance) and potentially cause job losses in export industries.

The Effects of Depreciation (The currency gets weaker)

1. Exports become cheaper:

  • If the Euro depreciates, US buyers need fewer Dollars to buy the same Euro-priced item.
  • This usually leads to a rise in the quantity of exports demanded.

2. Imports become more expensive:

  • Eurozone buyers need more Euros to buy the same Dollar-priced import.
  • This usually leads to a fall in the quantity of imports demanded.

Overall consequence: Depreciation tends to boost domestic firms that export and discourages imports. This can improve the Balance of Payments and boost domestic employment. However, imports being more expensive can lead to imported inflation.

The Crucial Role of Price Elasticity of Demand (PED)

The success of a depreciation depends entirely on the PED for exports and imports.

Remember: \(\text{PED} = \frac{\%\,\text{Change in Quantity Demanded}}{\%\,\text{Change in Price}}\)

Scenario: The country depreciates its currency to boost exports.

  • Exports are cheaper (price falls).
  • If the demand for exports is Price Elastic (\(PED > 1\)), the quantity demanded increases by a greater percentage than the price fell. This means the total revenue from exports increases significantly. (Depreciation is successful).
  • If the demand for exports is Price Inelastic (\(PED < 1\)), the quantity demanded barely increases. Since the price fell, total revenue from exports will decrease. (Depreciation is unsuccessful).

Did you know? Currencies for basic, essential goods (like food) tend to have inelastic demand, meaning a depreciation might not boost sales volume enough to increase total revenue.

Floating vs. Fixed Exchange Rate Systems (6.3.5)

Governments must choose how they manage their currency's value. The two main systems are Floating and Fixed.

1. Floating Exchange Rate System

The currency value is determined solely by the market forces of demand and supply (as discussed above). The government rarely intervenes directly.

  • Terminology check: When a currency changes value under a floating system, we call it Appreciation (up) or Depreciation (down).
2. Fixed Exchange Rate System

The government (or Central Bank) legally fixes the value of its currency against another currency (like the US Dollar) or a basket of currencies.

  • Intervention is key: The Central Bank must constantly intervene in the Forex market to maintain the fixed rate.
  • To prevent the currency from falling, the Central Bank must buy its own currency (increasing demand).
  • To prevent the currency from rising, the Central Bank must sell its own currency (increasing supply).
  • Terminology check: When a government officially changes a fixed rate:
    • Increasing the rate is called Revaluation.
    • Decreasing the rate is called Devaluation.
Comparing the Systems: Advantages and Disadvantages

Fixed Exchange Rate System

Advantages
  • Stability and Confidence: Businesses know the exact cost of imports and revenue from exports, reducing uncertainty and encouraging trade and investment.
  • Controls Inflation: Governments must manage their economy carefully to avoid inflation that would make their fixed currency rate unsustainable.
Disadvantages
  • Requires Large Reserves: The Central Bank needs huge reserves of foreign currency to constantly intervene (buy/sell).
  • Loss of Policy Control: The government may have to sacrifice domestic macroeconomic goals (like maintaining low interest rates) to keep the fixed rate stable.
  • Risk of Crisis: If speculators believe the rate is unsustainable, massive selling can force a sharp, painful Devaluation.

Floating Exchange Rate System

Advantages
  • Automatic Adjustment: The rate automatically adjusts to solve balance of payments issues. A deficit leads to depreciation, which makes exports cheaper and imports expensive, correcting the deficit.
  • No Need for Reserves: The Central Bank does not need to hold large reserves of foreign currency.
  • Independent Policy: The government is free to use interest rates for domestic goals (like controlling inflation or boosting growth).
Disadvantages
  • Uncertainty: Businesses face high uncertainty regarding future prices, which discourages international investment and trade.
  • Speculation Risk: Speculative activity can cause wild swings in the currency value, destabilizing the economy.
  • Lack of Discipline: Governments may be less disciplined in controlling inflation, knowing that depreciation will occur automatically.

Key Takeaway: The choice between Fixed and Floating involves a fundamental trade-off: Do you prioritize stability for trade (Fixed) or policy independence and automatic balance of payments correction (Floating)?