Exchange Rate

Definition:

An exchange rate is how much of one currency can be exchanged for one unit of another currency.

For example

If the exchange rate of the US dollar to the European euro is 0.81, this means that each US dollar can
be exchanged for 0.81 euros, or every 100 US dollars can be exchanged for 81 euros. Yet, exchange
rates are typically floating, meaning the exchange rate can fluctuate according to the global supply
and demand for foreign exchange.

The law of supply and demand tells us that if demand for an item increases, then the price of that
item generally increases. In contrast, if the supply of an item increases, then the price of that item will
generally decrease. Foreign currency is no different, and exchange rates represent the price at which
foreign currency is purchased and sold.

Exchange rates also affect the things we buy every day and the things we sell to other countries. Since
producers want payment for their goods in their own currency, a change in the exchange rate affects
the price of imports and exports. For example, if the dollar appreciates relative to the euro, then that
bottle of French wine you had your eye on will become cheaper to you.  However, the bottle of
California wine will be more expensive to French consumers and will have a more difficult time
selling there.

Exchange rate systems

There are three types of exchange rates:

1. Floating or flexible exchange rate.

2. Fixed exchange rate.
3. Partially flexible exchange rate system.

1. Floating exchange rates

Where the exchange rate is floating (as are all major currencies in the world), it will be determined by
market forces - that is supply and demand. As in any other market, the rate will change constantly to
reflect how much of the currency is being traded. The floating exchange rate can be determined by
demand and supply.

Let's take the Baht (the Thai currency) as an example and look at the factors that affect supply and
demand and therefore the equilibrium exchange rate.

Demand for baht

The people who demand baht are those who have bought goods and services from Thailand and need
to pay in baht. To do this they need to sell (supply) their currency and buy (demand) baht in exchange.
So, the demand for baht is partly determined by the level of exports - the higher the level of exports,
the higher the demand for baht. However, people may also demand baht simply because they want to
invest in Thailand or because they are speculating to make a profit, as they believe that exchange rates
will change. So the demand for sterling arises from:

 Exports
 Inflows of funds into Thailand
 Speculation

Supply of baht

The supply of baht comes from people who are selling baht to buy other currencies. We all do that
when we travel overseas - we sell baht and buy Euros, $, Yen or whatever. However, we, as tourists,
are only a very small part of overall supply of baht. Much of it will come from firms who buy goods
and services from overseas (imports), but there may also be outflows of funds and perhaps
speculative flows as well. So, the supply of baht arises from:

 Imports
 Outflows of funds from Thailand
 Speculation

Equilibrium in the market for baht will therefore look as in Figure 1 below.
If exports were to rise significantly, then this would cause an increase in demand for baht and would
shift the demand curve to the right as shown in Figure 2. The exchange rate has appreciated from
$0.25 to the baht to $0.35 to the baht. This could also be caused by an increase in Thai interest
rates attracting higher demand for baht.

If imports rose, this would shift the supply curve for baht as more baht would be sold to enable the
importers to buy the required foreign exchange. This would shift the supply curve to the right as
shown in Figure 3 below. This could also be caused by an outflow of funds due perhaps to a loss of
confidence in baht.
Governments can use exchange rates to affect economic performance. A rising exchange rate, which
is often linked to an increase in base interest rates, leads to exports becoming more expensive but
imports falling in price. This would reduce part of the inflationary pressure within an economy. A fall
in the exchange rate would lead to the reverse and might help domestic businesses export more.

2. Fixed exchange rates

A fixed exchange rate system is one where the value of the exchange rate is fixed to another currency.
This means that the government have to intervene in the foreign exchange market to maintain the
fixed rate. The equilibrium exchange rate may be either above or below the fixed rate. In Figure 1
below, the equilibrium is above the fixed rate. There is a shortage of the national currency at the fixed
rate. This would normally force the equilibrium exchange rate upwards, but the rate is fixed and so
cannot be allowed to move. To keep the exchange rate at the fixed rate the government will need to
intervene. They will need to sell their own currency from their foreign exchange reserves and buy
overseas currencies instead. This has the effect of shifting the supply curve to S2 and as a result, their
foreign currency holdings will rise.
In Figure 2, the opposite is true - the equilibrium rate is below the fixed rate. This means that there is
a surplus of the national currency. The government will need to buy this surplus if they are to prevent
the currency from falling - in other words keep it at the fixed rate. When they buy the currency they
will be selling from their foreign currency reserves and so these will fall, but the demand for domestic
currency will rise.

3. Partially Flexible Exchange Rate

In a partially flexible exchange rate the government sometimes affects the exchange rate and
sometimes leaves it to the market. Most nations have opted for a policy, partially flexible exchange
rates, that stand between these two extremes. Sometimes, these are referred to as “managed” exchange
rates or a “dirty” float. If policy makers believe there is a fundamental misalignment in a country’s
exchange rate, they allow market forces to determine it. If they believe the currency’s value is falling
because of speculation, they step in and fix the exchange rate, either supporting or pushing down their
currency’s value. Partially flexible exchange rate regimes combine the advantages and disadvantages
of fixed and flexible exchange rates.

Advantages and disadvantages of fixed exchange rate system

Advantages of fixed exchange rates

 Certainty - with a fixed exchange rate, firms will always know the exchange rate and this
makes trade and investment less risky.
 Absence of speculation - with a fixed exchange rate, there will be no speculation if people
believe that the rate will stay fixed with no revaluation or devaluation.
  Constraint on government policy - if the exchange rate is fixed, then the government may
be unable to pursue extreme or irresponsible macro-economic policies as these would cause a
run on the foreign exchange reserves and this would be unsustainable in the medium-term.

Disadvantages of fixed exchange rates

 The economy may be unable to respond to shocks - a fixed exchange rate means that there
may be no mechanism for the government to respond rapidly to balance of payments crises.
 Problems with reserves - fixed exchange rate systems require large foreign exchange reserves
and there can be international liquidity problems as a result.
 Speculation - if foreign exchange markets believe that there may be a revaluation or
devaluation, then there may be a run of speculation. Fighting this may cost the government
significantly in terms of their foreign exchange reserves.
 Deflation - if countries with balance of payments deficits deflate their economies to try to
correct the deficits, this will reduce the surpluses of other countries as well as deflating their
own economies to restore their surpluses. This may give the system a deflationary bias.
 Policy conflicts - the fixed exchange rate may not be compatible with other economic targets
for growth, inflation and unemployment and this may cause conflicts of policies. This is
especially true if the exchange rate is fixed at a level that is either too high or too low.

Advantages and disadvantages of floating exchange rates

Advantages of floating exchange rates:

 Protection from external shocks - if the exchange rate is free to float, then it can change in
response to external shocks like oil price rises. This should reduce the negative impact of any
external shocks.
 Lack of policy constraints - the government are free with a floating exchange rate system to
pursue the policies they feel are appropriate for the domestic economy without worrying
about them conflicting with their external policy.
 Correction of balance of payments deficits - a floating exchange rate can depreciate to
compensate for a balance of payments deficit. This will help restore the competitiveness of
exports. There is a link to Figure 1 below which illustrates the operation of the automatic
adjustment mechanism under a floating exchange rate system.

Disadvantages of floating exchange rates:

  Instability - floating exchange rates can be prone to large fluctuations in value and this can
cause uncertainty for firms. Investment and trade may be adversely affected.
 No constraints on domestic policy - governments may be free to pursue inappropriate
domestic policies (e.g. excessively expansionary policies) as the exchange rate will not act as
a constraint.
 Speculation - the existence of speculation can lead to exchange rate changes that are
unrelated to the underlying pattern of trade. This will also cause instability and uncertainty for
firms and consumers.

Factors which affect exchange rates

Exchange rates will be affected by a number of factors. Considering these in relation to Australian
dollars (Aus $).

 Trade flows:

A surplus of exports over imports for Australia (a trade surplus) will cause an increase in demand for
Aus $ (overseas buyers need the Aus $'s to pay for the goods) and will therefore exert an upward
pressure on the exchange rate. This is illustrated in Figure 1 below.

Figure:Australian trade surplus - impact on exchange rate

However, a deficit situation in which Australia imports exceed exports (a trade deficit) will cause an
increase in supply of Aus $'s (Australian importers will need to supply Aus $'s to obtain the foreign
currency required to pay for the imports). This will exert a downward pressure on the exchange rate as
shown in Figure 2 below.
Figure: Australian trade deficits - impact on exchange rate

 Capital flows / interest rate changes / speculation

Capital flows exert a more important influence on exchange rates than trade flows. This is because the
fund managers of international financial organisations and multinational corporations, and rich
individuals, such as oil sheikhs, move more money around the globe on a daily basis than is accounted
for by trade alone. They do this to take advantage of differences in relative interest rates and changes
in exchange rates, or may be speculating on future movements in such variables. For the average
person / IB student, shifting funds from one commercial bank to another may yield some benefit in
terms of higher returns, but it is unlikely that the sums involved would be very great. However, for
large institutions, with millions/billions of $, yen, euro etc. at their disposal, even marginal differences
in interest rate returns will generate substantial sums of money.

Thus, remaining with the Australian example (see above), if interest rates were to fall below those in
other major world economies, or international speculators were pessimistic about the future of the
Australian economy, or suspected a large future depreciation in the Australian $, they might decide
to sell their holdings of Aus $ and convert them into yen. This would increase the demand for yen,
while increasing the supply of Aus $'s and cause a depreciation of the currency. This can be seen in
Figure below.
Figure: Australian capital outflows - impact on exchange rate

A currency crisis is caused when large numbers of speculators decide to sell their holdings of a
currency at the same time, causing its price to crash.

In the case of the opposite scenario, i.e. an increase in Australian interest rates relative to others or
greater optimism about the future of the Australian economy, speculators / fund managers might
decide to move funds currently being held in yen into Aus $'s. This would have the reverse effect. The
yen would depreciate in value as its supply increased and the Aus $ would appreciate as the demand
for it increased (denoted by a rightward shift of the demand curve for Aus $'s).

 Inflation

A higher rate of inflation in Australia than in other competitor countries would make Australian
exports less competitive and may lead to less exports being sold, depending on the price elasticity of
demand for exports. If this resulted in a worsening of the current account, the exchange rate would
depreciate. With less demand for exports and imports becoming relatively more price attractive, the
demand for Aus $'s would fall while the supply would increase. This is shown in Figure below.

Figure: Impact of higher inflation on the exchange rate

The opposite might be the case, i.e. an appreciation of the Aus $, if the rate of inflation in Australia
fell below that in other countries.

Inflation may also be a factor which currency speculators take into account when making decisions
about buying/selling currencies. If a very high, uncontrollable rate of inflation was expected (a hyper-
inflation), speculators might lose confidence in the currency and sell, causing a depreciation.
  Use of foreign currency reserves

Exchange rates, whether fixed or floating, are usually influenced by the actions of governments. Thus,
if the Australian government wished to exert an upward pressure on the Aus $ (perhaps as part of a
monetary policy to lower the rate of inflation), they could buy Aus $'s on the foreign exchange market
using their reserves of foreign currency. This would increase the demand for Aus $'s, causing an
appreciation, while increasing the supply of other currencies, exerting a downward pressure on them.

If the Australian government wishes to exert a downward pressure on the Aus $ (perhaps to make
exports more price competitive, increase aggregate demand and the level of employment), they would
sell Aus $'s and buy other currencies. This would increase the supply of Aus $'s, thus causing a
depreciation, while increasing the demand for other currencies.