MACROECONOMICS
Topic 9: The Exchange Rate
Exchange Rate Determination
• An exchange rate is the price of one currency in terms of
another currency
• Suppose we are considering two currencies: the
Singapore dollar (S$) and United States dollar (US$)
• Singapore is the domestic country and US is the foreign
country
The Effect of a change in the exchange rate
on export and import prices
• Suppose the exchange rate is: US$1 = S$1.26
• If the exchange rate increases to US$1 = S$1.20 the
S$ has appreciated against the US$
• If the exchange rate decreases to US$1 = S$1.29, the
S$ has depreciated against the US$
• If S$ has appreciated, export prices will rise, few
exports will be sold. The effect on export revenue
will depend on price elasticity of demand.
Exchange Rate Policy
• Two Types of Exchange Rate Policies:
1. Fixed exchange rate policy
2. Floating exchange rate policy
Fixed Exchange Rate Policy
• A fixed exchange rate is one, whose value is fixed against the
value of another currency and is maintained by the
government.
• The value may be set at a precise value or within a given
margin
• Government intervenes in the foreign exchange market
(buy/sell domestic currency) to ensure that the exchange rate
remains at that pre-determined value.
• For example, RMB has been fixed against the US dollar until
2005
Fixed Exchange Rate
Revaluation: A rise in a fixed exchange rate against other
currencies
Devaluation: A fall in a fixed exchange rate against other
currencies
Flexible Exchange Rate Policy
• Exchange rate is one which is determined
by market forces:
• Demand for $
• Supply of $
• Market equilibrium exchange rate:
- Demand for S$ = Supply of S$
- intersection of the demand and supply
curves
Flexible Exchange Rate Policy
• Appreciation: increase in the value of a currency against other
currencies
• Depreciation: decrease in the value of a currency against other
currencies
Causes of exchange rate fluctuations
• The value of the exchange rate is influenced by the current
account balance, direct and portfolio investment, speculation
and government action
Current account balance
An increase in a current account surplus would tend to cause
the value of the currency to rise. For example, if there is a
improved quality or successful advertising, export revenue
may rises relative to import expenditure, demand for the
country’s currency will increase. Therefore this increases the
exchange rate.
.
Causes of exchange rate fluctuations
Foreign Direct investment
Inward Foreign Direct investment will boost the demand for a
currency
In contrast, Outward Foreign Direct investment will increase
the supply of a currency
Causes of exchange rate fluctuations
Speculation
Foreign exchange trades and investment companies move
money around the world to take advantage of higher interest
rates and variations in exchange rates to earn a profits
Hot money can cause exchange rate fluctuations, at least in
the short run
Causes of exchange rate fluctuations
Government action
Government can seek to influence the value of its currency in
three main ways
One is buying and selling the currency. If it wants to raise the
exchange rate, it will instruct its central bank to buy the
currency.
A central bank may also raise the interest rate, in a bid to
raise the value of the currency. A higher interest rate may
also attract hot money flows
A government may try to raise the value of the currency by
introducing measures to increase exports and reduce import
Consequences of exchange rate fluctuations
• A fall in the exchange rate would be likely to improve the
current account position, boost economic growth and
employment but may also tend to increase inflationary
pressure
Current account position
• A government can seek to improve current account position
by encouraging domestic and foreign citizens to buy more
domestic products
• It make domestic products more internationally competitive
• This may raise export revenue and lower import expenditure
if demand for exports and imports is elastic
Consequences of exchange rate fluctuations
A decrease in exchange rate will lower export prices and rise
import prices, is likely to increase demand for domestic products
Consequences of exchange rate fluctuations
Employment and Economic growth
• A fall in the international value of its currency may cause a
rise in net exports and profits, which will bring job gains in
export-oriented business in the long run. This will therefore
reduce unemployment if the economy is not operating at full
capacity initially.
• The higher output and GDP will bring economic growth, and
improve household' living standards.
Consequences of exchange rate fluctuations
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 CPI and hence a rise in their
price will directly boost inflation
Question
• Discuss whether a fall in the international value of
its currency will always benefit an economy.
Improve current account position
• Lower export prices/ raise import prices
• raise export revenue and lower import expenditure
• Make domestic product more internationally
competitive if the price is elastic
Question
Reduce unemployment
• export-oriented business may produce more
domestic products
• raise output/GDP
• The higher GDP will bring economic growth, and
improve household' living standards
Question
Higher import prices cause inflation
• raise costs of raw materials and increase costs of
production
• put pressure on domestic firm to lower price
competitive
Demand for exports may be price inelastic
• export revenue decrease/ import expenditure rise
