Economics (9640) | Exchange rates

Exchange Rates: The Price of Money

Welcome to the fascinating world of Exchange Rates! This chapter links together everything you've learned about international trade and the balance of payments. Why is this important? Because the exchange rate is essentially the 'price tag' that connects your domestic economy to the rest of the world. A small change here can drastically affect inflation, exports, jobs, and economic growth.

Don't worry if currency markets seem complicated. We will break them down using the simple tool you already know: Supply and Demand!

1. What Exactly is an Exchange Rate?

An exchange rate is simply the price of one currency expressed in terms of another currency.

• If the exchange rate is $1 = ¥150, it means you must pay 150 Japanese Yen to buy 1 US Dollar.
• It is quoted as the amount of foreign currency needed to buy one unit of the domestic currency (e.g., Yen per Dollar).

Key Terminology: Floating vs. Fixed Systems

It is crucial to use the correct terms depending on whether the exchange rate is determined by the market or by the government:

• Appreciation (Floating System): The value of a currency rises relative to another currency. (It takes FEWER units of the domestic currency to buy the foreign currency, OR it takes MORE units of the foreign currency to buy the domestic currency.)
• Depreciation (Floating System): The value of a currency falls relative to another currency.
• Revaluation (Fixed/Managed System): A deliberate upward adjustment of the currency's value by the government or central bank.
• Devaluation (Fixed/Managed System): A deliberate downward adjustment of the currency's value by the government or central bank.

Quick Tip: Appreciation and Depreciation happen naturally in the market (like any price change). Revaluation and Devaluation are policy choices (they are "decided").

2. Determination of Exchange Rates (Freely Floating System)

In a freely floating exchange rate system, the value of the currency is determined purely by the forces of demand and supply in the foreign exchange market, just like the price of any good or service.

The Market for Currency (e.g., the Market for Sterling, £)

Demand for Sterling (£)

The demand curve for a currency slopes downwards (as the price of the pound falls, the quantity demanded rises). Demand for a currency comes from anyone who needs that currency to pay for something from the home country (the UK, in this example).

• Exports of Goods & Services: Foreigners buy UK goods/services (e.g., US tourists visiting London need Pounds).
• Inward Foreign Direct Investment (FDI): Foreign firms building factories in the UK need to convert their currency into Pounds to pay for land and labour.
• Inward Portfolio Investment: Foreigners buying UK financial assets (e.g., government bonds or shares in UK companies).
• Speculation: Traders expecting the Pound to appreciate later will buy it now.

Supply of Sterling (£)

The supply curve for a currency slopes upwards. Supply of a currency occurs when domestic citizens or firms want to sell their currency to buy foreign currency.

• Imports of Goods & Services: UK citizens buying goods/services from abroad (e.g., a UK person buying a Japanese car must sell Pounds to get Yen).
• Outward Foreign Direct Investment (FDI): UK firms building factories abroad (e.g., in France) need to sell Pounds to get Euros.
• Outward Portfolio Investment: UK citizens buying foreign financial assets.
• Speculation: Traders expecting the Pound to depreciate later will sell it now.

The equilibrium exchange rate is set where the Quantity Demanded for the currency equals the Quantity Supplied (D = S).

3. Causes of Changes in the Exchange Rate

Shifts in the Demand (D) or Supply (S) curves cause the exchange rate to change.

Factors Causing Appreciation (Increased Demand or Reduced Supply)

• Rise in Domestic Interest Rates (Relative to Abroad): Higher returns on savings and assets attract capital (portfolio investment) from overseas. This is often called hot money. (D shifts right, causing appreciation.)
• Lower Domestic Inflation (Relative to Abroad): UK exports become cheaper and more competitive. Foreigners demand more UK goods and therefore more Pounds. (D shifts right.)
• Higher Domestic Economic Growth (Relative to Abroad): This is ambiguous, but generally, high growth attracts FDI, increasing demand for the currency.
• Speculation: If financial traders believe the currency will rise in value, they will buy it now, making their prediction self-fulfilling (at least in the short term).

Memory Aid (Interest Rates): If the UK Central Bank raises interest rates, it's like putting up a sign saying "SALE on UK Savings!" Foreigners rush in to buy Pounds to save them, causing the Pound to appreciate.

Speculation and Herding Behaviour

Speculation is the act of buying or selling currency in anticipation of future changes in its value. It can be:

• Stabilising: Buying when the currency is low (preventing it from falling further) or selling when it is high.
• Destabilising: Buying when the currency is already rising (forcing it higher) or selling when it is already falling (forcing it lower).

Herding behaviour occurs when traders ignore fundamental economic factors and simply follow the actions of other major players in the market. This often amplifies market movements, leading to large, sudden fluctuations in the exchange rate.

4. Exchange Rate Systems

Governments choose how much control they want over their currency's value, leading to three main systems:

A. Freely Floating Exchange Rate System

The exchange rate is determined entirely by market forces (D and S).

• Advantages:
  1. Automatic Correction: A current account deficit (too many imports) causes an increase in the supply of the currency, leading to depreciation, which automatically makes exports cheaper and imports more expensive, solving the deficit over time.
  2. Policy Autonomy: The central bank is free to use interest rates solely for domestic goals (like controlling inflation) without worrying about maintaining a specific exchange rate.
• Disadvantages:
  1. Volatility and Uncertainty: Exchange rates can fluctuate wildly due to speculation or sudden events, making long-term planning difficult for firms (discourages investment).
  2. Inflation Risk: Depreciation can cause imported goods and raw materials to become more expensive, leading to cost-push inflation.

B. Fixed Exchange Rate System

The currency's value is pegged to another currency (like the US Dollar) or a commodity (like Gold).

• Advantages:
  1. Stability and Certainty: Reduces risk for importers and exporters, encouraging international trade and investment (FDI).
  2. Reduced Inflation: Requires the country to keep its inflation rate in line with the anchor currency, which imposes discipline on the government's economic policy.
• Disadvantages:
  1. Loss of Autonomy: The government loses control over monetary policy (interest rates must be used to defend the fixed rate, not to control the domestic economy).
  2. Need for Reserves: Requires the central bank to hold large foreign currency reserves to buy its own currency if its value starts to fall below the peg.
  3. Risk of Devaluation: If a country maintains an unsustainable fixed rate, it may be forced into a politically embarrassing devaluation.

C. Managed Float (Hybrid System)

The exchange rate is allowed to fluctuate freely, but the central bank steps in occasionally (through buying/selling currency) to prevent excessive volatility or steer the rate toward a desired level.

5. Impacts of Exchange Rate Changes on the Economy

Changes in the exchange rate have widespread effects on aggregate demand (AD), inflation, and the balance of payments.

A. Effects of a Currency Appreciation (e.g., £ gets stronger)

• Impact on Trade Balance (X-M):
  • Exports (X) become more expensive for foreigners, so X falls.
  • Imports (M) become cheaper for domestic consumers, so M rises.

  • Net exports (X-M) falls, leading to a fall in AD (\(AD \downarrow\)).

• Impact on Inflation:
  • Imported raw materials and finished goods are cheaper. This reduces cost-push inflation.
  • The fall in AD reduces demand-pull inflation.
• Impact on Firms/Individuals:
  • Exporters lose competitiveness and may face job losses.
  • Importers and consumers benefit from cheaper foreign goods.

B. Effects of a Currency Depreciation (e.g., £ gets weaker)

This is generally the opposite of appreciation and is often used as an expenditure-switching policy to correct a current account deficit.

• Impact on Trade Balance (X-M):
  • Exports become cheaper, so X rises.
  • Imports become more expensive, so M falls.

  • Net exports (X-M) rises, leading to a rise in AD (\(AD \uparrow\)).

• Impact on Inflation:
  • Imported raw materials and finished goods are now more expensive. This increases cost-push inflation.
  • The rise in AD increases demand-pull inflation.
• Impact on Firms/Individuals:
  • Exporters gain competitiveness and see increased profits/jobs.
  • Consumers suffer from higher prices for imported goods.

6. Government Intervention and the IMF

Government Intervention to Influence Rates

A government or central bank (like the Bank of England) can intervene to stabilize or shift the exchange rate:

1. Buying/Selling Currency in the Forex Market:
   • To prevent depreciation, the central bank buys its own currency using foreign reserves (increasing demand for its currency).
   • To prevent appreciation, the central bank sells its own currency, buying foreign currency (increasing supply of its currency).
2. Adjusting Interest Rates:
   • Raising interest rates attracts hot money inflows, increasing demand for the currency and causing appreciation.
   • Lowering interest rates causes capital outflows, increasing supply and causing depreciation.

The Role of the International Monetary Fund (IMF)

The IMF is an international organization (part of the UN system) that aims to foster global monetary cooperation, secure financial stability, and facilitate international trade.

• Lender of Last Resort: It provides financial assistance (loans) to countries facing severe balance of payments crises (where they cannot afford to pay for essential imports or service their debts).
• Promoter of Stability: It provides advice and technical assistance on economic policy, often urging countries to adopt structural reforms to ensure sustainable economic growth and financial stability.