Foreign exchange rates
For example, if the exchange rate between the US Dollar () and the Euro (€) is 1.20, it means1 = €1.20 or €1 = $0.83.
Why this matters: Exchange rates determine the relative cost of imports and exports, influencing a country's balance of payments and inflation levels.
Depreciation: A decrease in the value of a currency relative to another currency in a floating exchange rate system.
To understand exchange rates, we must look at what drives the demand for and supply of a currency. These transactions occur for several specific reasons:
- Trade in Goods and Services: Importers need to buy foreign currency to pay for imports; exporters sell foreign currency earnings to buy domestic currency.
- Speculation: Investors buy currencies they expect to appreciate to make a profit from the exchange rate difference.
- Government Intervention: Central banks may buy or sell their own currency to influence its value (e.g., to stabilize trade).
- Payment of Profit, Interest, and Dividends:
- Profits: Multinational companies repatriate profits earned abroad back to the home country, requiring currency conversion.
- Interest: Investors holding foreign bonds receive interest payments in the foreign currency, which they may then sell for their home currency.
- Dividends: Shareholders receiving dividends from foreign companies must convert those foreign currency payments into their home currency.
- Workers' Remittances: Workers employed abroad send earnings back to their home country, creating demand for the home currency and supply of the foreign currency.
- Investment in Capital Goods: Countries or firms buying foreign machinery, factories, or assets must exchange their domestic currency for the foreign currency.
In the foreign exchange market, the exchange rate is determined by the interaction of demand and supply.
Demand for a Currency (e.g., Domestic Currency):
Demand comes from those who need to buy the domestic currency. This includes:
- Exporters selling their goods abroad (they earn foreign currency and sell it for domestic currency).
- Foreign investors buying domestic assets (stocks, bonds, property).
- Speculators expecting the currency to appreciate.
Supply of a Currency (e.g., Domestic Currency):
Supply comes from those who want to sell the domestic currency. This includes:
- Importers needing foreign currency to pay for imports (they sell domestic currency to buy foreign currency).
- Domestic investors buying foreign assets.
- Speculators expecting the currency to depreciate.
| Effect on Supply of Domestic Currency |
|---|
| Decreases (less incentive to invest abroad) |
| Increases (imports become cheaper, so more domestic currency is sold) |
| Increases (more imports require selling domestic currency) |
The equilibrium exchange rate is the rate at which the quantity of a currency demanded equals the quantity supplied. It is found where the demand curve (D) intersects the supply curve (S).
- If the market rate is above equilibrium, there is a surplus (excess supply), putting downward pressure on the rate.
- If the market rate is below equilibrium, there is a shortage (excess demand), putting upward pressure on the rate.
Causes of Fluctuations:
The equilibrium rate changes when demand or supply shifts:
- Changes in Demand for Exports/Imports: If foreign demand for exports rises, demand for domestic currency increases (D shifts right), causing appreciation.
- Changes in Interest Rates: Higher domestic interest rates attract foreign investment, increasing demand for the currency and causing appreciation.
- Speculation: If investors believe a currency will rise, they buy it now, shifting demand right immediately.
Analysis:
- Exports: Domestic goods become cheaper for foreigners. For example, if a car costs 10,000 and the exchange rate moves from1=€1 to 1=€0.90, the car now costs €9,000 instead of €10,000. This increases the <strong>price competitiveness</strong> of exports.</li> <li><strong>Imports</strong>: Foreign goods become more expensive for domestic consumers. A foreign phone costing €1,000 now costs1,111 instead of $1,000.
Result: Quantity of exports rises; quantity of imports falls. This improves the balance of payments (assuming the Marshall-Lerner condition holds).
Mistake: Students often state that a 'current account surplus causes depreciation' or 'depreciation causes a surplus' without clarifying the direction.
Correction:
- A surplus (excess demand for currency) typically leads to appreciation in a floating system.
- Depreciation is often used as a policy tool to cause an improvement in the current account by making exports cheaper. Do not confuse the initial cause with the resulting effect on trade volumes.
Why examiners accept this: Examiners look for the link between currency value and import prices. A weak currency makes imported raw materials and finished goods more expensive, leading to cost-push inflation. It also boosts aggregate demand, leading to demand-pull inflation.
Correct Phrasing: 'A depreciation increases the price of imported inputs, raising production costs for domestic firms (cost-push inflation). Additionally, increased net exports raise aggregate demand, potentially causing demand-pull inflation if the economy is near full employment.'
Example: 'The fall in the exchange rate made oil imports more expensive, increasing transport costs and contributing to higher consumer prices.'
Why examiners accept this: Examiners want specific economic mechanisms, not just 'exports increase'. You must mention price competitiveness and aggregate demand.
Correct Phrasing: 'Depreciation improves price competitiveness of exports, leading to an increase in export revenue. This increases net exports (X-M), which is a component of Aggregate Demand (AD = C+I+G+(X-M)), thus stimulating economic growth.'
Example: 'The depreciation made domestic tourism cheaper for foreigners, increasing demand for local hotels and boosting AD.'
- To stabilize the exchange rate and reduce uncertainty for traders. 2. To prevent excessive appreciation/depreciation that harms exports/imports.
Disadvantages: Imports become more expensive, causing cost-push inflation (1). If the economy relies on imported raw materials, production costs rise, reducing profitability (1). The 'J-curve' effect means the trade balance may worsen initially before improving (1). If demand for exports is price inelastic, export revenue may fall (1).
Conclusion: It is beneficial only if the Marshall-Lerner condition holds and there is spare capacity to increase production.