FOREIGN EXCHANGE

RATE
CHAPTER 38
 Learning objectives
By the end of this chapter you will be able to:

 Define a foreign exchange rate

 Distinguish between a fixed and a floating exchange rate
 Explain how a foreign exchange rate is determined in a foreign
exchange market
 Analyze the causes of foreign exchange fluctuations
 Analyze the effects of foreign exchange rate fluctuations
 Discuss the advantages and disadvantages of floating and fixed
foreign exchange rates
 Foreign exchange rate

• Foreign exchange rate: the price of one currency in terms of another

currency or currencies.
• It is also the value of the currency – that is, how much the currency is worth
in terms of another currency (or currencies).
• For example, a foreign exchange rate of $1 = 3.67 UAE Dirham means that
the price of $1 is 3.67 UAE Dirham and that one dollar is worth (would buy)
3.67 UAE Dirham.
• A foreign exchange rate index is the price of one currency in terms of a
basket of other currencies, weighted according to their importance in the
country’s international transactions.
• For example, the Japanese effective exchange rate measures the value of
the Japanese yen against fifteen major currencies, including the US dollar,
the Chinese renminbi, the Korean won and the Thai baht.
 A Fixed Exchange Rate
• A fixed exchange rate is one whose value is fixed against the value of another currency
(or currencies) and is maintained by the government.
• The value may be set at a precise price or within a given margin.
• If market forces are pushing down the value of the currency, the central bank will step in
and seek to increase its value, either by buying the currency or raising the rate of interest.

 In Figure 38.1, the price of one US dollar is initially two

euros.

 Demand for the dollar rises and, if left to market forces, its
price would rise to 2.4 euros.

 If, however, the central bank wants to keep the price of the
dollar at two euros, it may ask its central bank to sell
dollars. If it does so, the supply of dollars traded on the
foreign exchange market will increase and price may stay
at two euros.
Devaluation Revaluation

A change in the value of the currency from one A rise in a fixed exchange rate is called a revaluation.
exchange rate to a lower one is referred to as
devaluation
 Some Major Fixed Currencies
Major Fixed Currencies

Currency
Country Region Code Peg Rate Rate Since
Name

Bahrain Middle East Dinar BHD 0.38 1981

Belize Central America Dollar BZD 2.00 1977
Djibouti Africa Franc DJF 177.72 1974
Eritrea Africa Nakfa ERN 15.07 2017
Hong Kong Asia Dollar HKD 7.83 2022
Jordan Middle East Dinar JOD 0.71 1996
Lebanon Middle East Pound LBP 1,507.5 1999
Oman Middle East Rial OMR 0.38 1987
Panama Central America Balboa PAB 1.00 1904
Qatar Middle East Riyal QAR 3.64 1981
Saudi Arabia Middle East Riyal SAR 3.75 1987

United Arab
Middle East Dirham AED 3.67 1998
Emirates
 A Floating Exchange Rate

 A floating exchange rate is one which is determined by market forces. If

demand for the currency rises or the supply decreases, the price of the
currency will rise. Such a rise is referred to as an appreciation.
 In contrast, a depreciation is a fall in the value of a floating exchange
rate.

 It can be caused by a fall in demand for the

currency or a rise in its supply. Figure 38.2

 shows a decrease in demand for

Bangladeshi taka, causing the price of the
taka to fall.
TIP
 In explaining how a floating exchange rate is determined, it is useful
to draw a diagram. Remember that on the vertical axis of an exchange
rate diagram, you should express the price of the currency in terms
of another currency.
 The determination of a foreign exchange
rate in a foreign exchange market
Currencies are bought and sold on foreign exchange markets.
 Individuals, firms and central banks may buy and sell foreign
currencies.
The main traders are, however, commercial banks. These buy currencies
for their customers and to speculate on movements in the price of
currencies.
The key reasons why currencies are bought and sold are linked to
speculation, demand
for exports and imports, the purchase and sale of financial assets and
foreign direct investment (FDI) often carried out by multinational
companies.
These and other reasons are examined in more depth NOW.
 The reasons for the demand and supply of
currency in a foreign exchange market
 As we discussed there are a number of reasons for individuals, banks,
firms and governments to buy and sell a currency.
 These reasons can be examined in more depth by considering the
specific example of demand and supply of Indian rupees, as shown in
Table 38.1.
 The effect of a rise in the interest rate
Figure 38.3

Shows the effect of a rise in the Indian rate of

interest on the market for Indian rupees.
This will encourage foreigners to place money
in Indian banks and hence, increase the
demand for Indian rupees and raise its price.

TIP
Think carefully about which curve or curve
will shift when there is a transaction involving
foreign exchange. Remember, for example,
that when we buy imports we sell our own
currency and this purchase causes the supply
curve to shift to the right.
 The causes of Exchange Rate Fluctuations

An exchange rate may change as a result of

1. A change in export revenue and import expenditure,

2. Foreign Direct Investment (FDI)
3. The sale and purchase of financial assets between the country and
other countries.
4. Speculation and central bank action.
 Example of Exchange Rate Fluctuation

• For example, if export revenue rises relative to import expenditure,

demand for the currency will rise.
• An increase in investment in the country arising from a foreign
multinational company setting up a production plant can also cause
the price of the currency to rise.
• If it is generally believed that the currency will rise in price,
speculators will act in a way which will help in bringing about their
expectation. They will buy the currency which, in the case of a
floating exchange rate, will push up its price.
How Govt. and its central bank can effect ER(PRICE
OF THIER CURRENCY)?
There are three ways.
1. One is by buying and selling the currency.
If it wants to raise the exchange rate, it will instruct its central bank to buy the currency, using foreign
currency to do so. But there is a limit to which it can do this, as it will have a limited supply of foreign
currency in its reserves.
2.A central bank may also raise the rate of interest,
in a bid to raise the value of the currency. A higher interest rate may attract what are called hot money
flows.
hot money flows are funds, which are moved around the financial markets of the world, to take advantage
of
differences in interest rates and exchange rates. If more people want to place money into the country’s
financial institutions, it will increase the demand for the currency
3. a government may try to raise the value of the currency by introducing measures to increase exports
and reduce imports.
 The consequences of a change in the
exchange rate

A. The effect of a change in the exchange rate on export and import prices
A rise in a country’s exchange rate would raise the price of its exports and lower the
price of its imports. More precisely, the price of exports rises in terms of foreign
currency and the price of imports falls in terms of the domestic currency.
 For example
• Initially 80 Indian rupees may equal £1.
• (1÷80=0.0125 1 rupee equals 0.0125 pounds
• The Indian export valued at 800 rupee 0.0125 pounds*800 rupees=10 pounds
• In this case, an Indian export valued at 800 rupees will sell in the UK at £10
(80*10=800)
• A UK import valued at £20 will sell in India for 1600 rupees (20*80=1600).
• If India experiences a rise in its exchange rate against the pound sterling, it means
that rupees will buy more pounds now.
• The value of the rupee may rise so that 80 rupees equal £2.
• This significant rise would mean that the Indian export would now sell for £20 in the
UK and the £20 import from the UK would sell for 800 rupees in India.
• If export prices rise, fewer exports will be sold.
• The effect on export revenue will depend on price elasticity of demand. If demand is
elastic, the rise in price will cause a fall in revenue whereas if demand is inelastic,
revenue will rise. In practice, in many export markets there is considerable competition
from firms throughout the world and hence the demand is elastic.
 B. The effect of a change in the exchange rate on the
macroeconomy
• A change in the exchange rate, besides
affecting exports and imports, may influence
economic growth, employment and inflation.
• A fall in the exchange rate, by lowering
export prices and raising import prices, is
likely to increase demand for domestic
products.
• This rise in aggregate demand can increase
output and employment of the economy, if it
is not operating at full capacity initially.
Figure 38.4 shows real GDP rising from Y to
Y1 as a result of a rise in net exports.
A fall in ER can increase Inflationary Pressure
A fall in the exchange rate can, however, increase inflationary pressure for a number
of reasons.

Imported raw materials will be more expensive, which will raise the costs of
production.
 Finished imported products will also be more expensive. These appear in the
country’s consumer prices index and hence a rise in their price will directly boost
inflation.
It will also increase inflation indirectly, by reducing the pressure on domestic
firms to keep price-rise to a minimum, in order to remain competitive.
 The advantages and Disadvantages of
floating and fixed foreign exchange rates

Advantages

An advantage of a floating exchange rate is that it may help to eliminate

a gap between export revenue and import expenditure.
• If demand for imports rises whilst demand for exports falls, supply of the
currency will rise (as individuals and firms sell it to buy foreign currency)
and demand for the currency will fall.
• This will lower the value of the currency and hence reduce export prices
and raise import prices. These changes may make export revenue and
import expenditure balance.
Disadvantages of floating Exchange Rate

firstly, Even with a deficit between what the country has earned from exports and
what it has spent on imports, however, demand for the currency may rise.
Firms and individuals may still buy more of the currency to invest in the country,
if they think that economic prospects are good.
So, in practice, there is no guarantee that a floating exchange will eliminate a
current account deficit.
A floating exchange rate, nevertheless, does allow a government to concentrate on
other objectives. It also means that a government does not have to keep reserves of
foreign currency to influence the price of its currency.
secondly, floating exchange rate can fluctuate, making it difficult for firms to
plan ahead. Speculation may cause significant changes in the price of a currency.
A large depreciation may result in a rise in the country’s inflation rate. This is why,
on occasions, a central bank may still intervene despite usually leaving the
exchange rate to be determined by market forces.
The advantages and disadvantages of fixed exchange rates
Advantage
Fixed Exchange rate creates certainty.
Firms that buy and sell products abroad will know the exact amount they will pay and
receive in terms of their own currency, if the exchange rate does not change.

Disadvantages.
It can mean that a central bank has to use up a considerable amount of foreign currency
to maintain its value. If the exchange rate is under downward or upward pressure, it may
also have to implement policy measures which may conflict with its other government
objectives.
For example, a central bank may raise the rate of interest to reverse downward pressure
on the value of the currency. A higher interest rate may cause unemployment and slow
down economic growth as it may reduce aggregate demand. Finally, if a government
cannot maintain an exchange rate at a given value, it may have to change its price and
this may cause a loss of confidence in the economy.
 International competitiveness
A country might be called internationally competitive, if it provides the goods and services
desired by consumers at a price acceptable to them.
There are a number of indicators of a country’s international competitiveness.
These include its

1. Economic growth rate,

2. Its share of world trade,
3. Levels of expenditure on research and development
4. The quantity and quality of education and training
5. The state of the country’s infrastructure.
6. A competitive economy is likely to have a stable economic growth rate, a reasonable share of
world trade, high levels of investment and expenditure on research and development, good
quality education and training and developed infrastructure.
 In the short term, changes in a country’s exchange rate and inflation rate
can influence its international competitiveness.

 A fall in both would be likely to make the country’s products more attractive to
buyers at home and abroad.

 Changes in productivity, however, will have long-lasting effects. Productivity

can be raised by, for example, investment, education and training and improved
working conditions.
Thanks