6.3 – Foreign Exchange Rates

The foreign exchange rate is the value or price of a currency expressed in terms of another currency. For example, £1 = $1.2
This exchange rate will be used when these countries trade and need to convert money. So if a person were to convert £100 into dollars, he would get $120 (100 * 1.2).

The foreign exchange rate of each currency is determined by the market demand and supply of the currency. 

• Demand for the a currency, say the pound sterling, exists when foreign consumers want to buy and import goods and services from the UK, when overseas companies buy pounds to invest in the UK etc. Here, the UK’s currency is being demanded abroad.
• Supply of a currency, say the pound sterling, exists as UK consumers want to buy and import goods and services from other countries, when UK companies buy foreign currencies to invest abroad. Here the UK’s currency is being supplied abroad.
• The price at which demand and supply of the currency equals is the equilibrium market foreign exchange rate value of a currency against another currency. An increased supply and decreased demand causes the exchange rate to fall, while a decreased supply and increased demand causes the exchange rate to rise.

Causes of foreign exchange rates fluctuations:

• Changes in the demand for exports and imports: when a country’s import value is greater than its export value (which is a deficit), it means that more of their currency is being supplied (going out) than being demanded. The exchange rate for the country’s currency will fall. If there is a surplus in the current account, the exchange rate will rise.
• Inflation: if the inflation in a country is higher than that of other countries it trades with, the price of that country’s goods in the international market will be higher compared to goods from other countries. The demand for the country’s goods will fall and the so the currency demand will also fall, causing a fall in exchange rate.
• Changes in interest rate: if a country’s interest rate rises, overseas residents may be keen to save or invest money in that country. The demand for the currency will rise, and the exchange rate will rise. If interest rates fall below that of other countries, the currency will fall in value as overseas demand falls.
• FDI/MNCs: globalisation and economic activities of multinational companies mean that investment in overseas production plants requires the use of foreign currencies. For example, a US company with factories in UK needs to pay its labour with pound sterling, not with the US dollars, increasing the demand for the pound. Thus, inward FDI will boost the demand for a currency and increase its foreign exchange value. In contrast, outward FDI will increase the supply of a currency and cause its foreign exchange rate to fall.
• Speculation: foreign exchange traders and investment companies move money around the world to take advantage of higher interest rates and variations in exchange rates to earn a profit. As huge sums of money are involved (known as ‘hot money’), this can cause exchange rate fluctuations, at least in the short run. If speculators lack confidence in the economy they will withdraw their investments in that country, thereby causing a fall in the value of the currency. In contrast, high confidence in the economy will invite investments and raise the foreign exchange value of the currency.
• Government intervention: government intervention in the foreign exchange market can affect the exchange rate. For example, if greater demand for British goods causes a rise in the value of the pound, the Bank of England (UK’s central bank) can sell their reserves of pound sterling in the foreign exchange market to increase it’s supply and cause a fall in its value.

Consequences of foreign exchange rate fluctuations:

• A fall in the foreign exchange rate causes import prices to rise and export prices to fall.
  A fall in the foreign exchange rate, of say the pound, means that now you have to pay more pounds when you’re importing an American good to the UK, for example. If the initial exchange rate is $1 = £0.8, and the original price of the good was $2, you’d have to pay £1.6 ($2 * £0.8) to buy the good. Now, suppose the exchange rate falls to $1 = £1 (a pound is now worth lesser dollars), you’d have to pay £2 ($2 * £1) to buy the good.
  Similarly, a fall in the foreign exchange rate of the pound means that now you’ll to get fewer dollars when you’re exporting a British good to America. Using the initial exchange rate as described above, an export initially costing £2 means American consumers will have to pay $2.5 (£2 / £0.8) to buy it. After the exchange rate falls, they will have to pay only $2 (£2 / £1).
• A rise in the foreign exchange rate causes import prices to fall and export prices to rise.
  A rise in the foreign exchange rate, of say the pound, means that now you have to pay fewer pounds when you’re importing an American good to the UK, for example.
  If the initial exchange rate is $1 = £0.8, and the original price of the good was $2, you’d have to pay £1.6 ($2 * £0.8) to buy the good. Now, suppose the exchange rate rises to $1 = £0.5 (a pound is now worth more dollars), you’d have to pay only £1 ($2 * £0.5) to buy the good.
  Similarly, a rise in the foreign exchange rate of the pound means that now you’ll get more dollars when you’re exporting a British good to America. Using the initial exchange rate as described above, an export initially costing £2 means American consumers will have to pay $2.5 (£2 / £0.8) to buy it. After the exchange rate rises, they will have to pay $4 (£2 / £0.5).
• Now, if the country’s export and import demands are price elastic (relatively more sensitive to price changes), a fluctuation in the exchange rate and the subsequent changes in the prices of exports and imports will change the demand for them.
  A fall in exchange rate will make imports expensive and exports cheap, so import demand and spending will fall and export demand and spending will rise. 
  A rise in the exchange rate will make imports cheaper and exports expensive, so import demand and spending will rise and export demand and spending will fall.
• Hence, we can conclude that when PED > 1 (elastic), a fall in foreign exchange rate will improve the trade balance (reduce deficits) of the country as exports will rise relative to imports.
• On the other hand, when PED < 1 (inelastic), a rise in foreign exchange rate will worsen the trade balance (but reduce surplus) of the country as imports will rise relative to exports.

Floating Foreign Exchange Rate

This is an exchange rate that is determined freely by market demand and supply conditions, and so will fluctuate regularly.

The rise in the value of one currency against others, on a floating exchange rate is known as appreciation of the currency.

The fall in the value of one currency against others, on a floating exchange rate is known as depreciation of the currency.

Advantages:

• Automatic Stabilisation: any disequilibrium in the balance of pay­ments would be automatically corrected by a change in the exchange rate. For example, if a country suffers from a deficit in the balance of payments, then the country’s currency should depreciate. This would cause the country’s import demand to fall (as imports become expensive) and export demand to rise (as export prices fall). The balance of payments equilibrium would therefore be restored. Similarly, a surplus would be eliminated as the currency appreciates.
• Frees up internal policy: a floating exchange rate allows a government to pursue internal policy objectives such as full employment and growth, not having to worry about balance of payments imbalances as they will be automatically adjusted.
• Insulated from external changes: a floating exchange rate helps to insulate a country from inflation elsewhere. If a country were on a fixed exchange rate then it would ‘import’ inflation through higher import prices. A floating exchange rate would automatically adjust demand and supply in the economy and avoid such external disturbances.
• Don’t need too much foreign reserves: under a floating exchange rate system, there is no need to maintain reserves to deliberately change the exchange rate. These reserves can therefore be used to import capital goods in order to promote faster economic growth.

Disadvantages:

• Uncertainty: since currency values fluctuate constantly, businesses, investors and consumers will be uncertain about the economy and its future. They may lose confidence in the economy if it fluctuates too rapidly.
• Lack of Investment: the uncertainty introduced by floating exchange rates may discourage direct foreign investment. They will prefer to invest in countries with fixed exchange rate systems where they can effectively predict economic conditions and act accordingly.
• Speculation: the day-to-day fluctuations in exchange rates may encourage speculative movements of ‘hot money’ from country to another, thereby causing more exchange rate fluctuations.
•  Lack of Discipline: the need to maintain an exchange rate imposes a discipline upon the national economy, which is absent in a floating exchange rate regime. With a floating exchange rate, short-run problems such as domestic inflation may be ignored until they lead to a crisis.

Fixed Foreign Exchange Rate

A fixed exchange rate is one that is fixed and controlled by the central bank, acting on behalf of the government of the country. The central bank will intervene in the market by buying and selling its currency in the foreign exchange market to maintain a fixed exchange rate.

A deliberate fall in the value of a fixed exchange rate is called a devaluation.
A deliberate rise in the value of a fixed exchange rate is called a revaluation.

Advantages:

• Certainty: since the currency value is kept in check, there will be more certainty in the economy and businesses, consumers, investors and governments won’t have to worry about the effects of automatic changes in exchange rate.
• Stability encourages investment: a fixed exchange rate provides greater certainty and encourages firms to invest. One of the reasons Japanese firms are reluctant to invest in UK is because the pound works on a flexible exchange rate (unlike the Euro which is on a fixed system), causing uncertainty about the economy.
• Keep inflation low: depreciation of a currency can cause inflation as demand, prices and costs for firms rise. On a fixed exchange rate, firms have an incentive to keep cutting costs to remain competitive.
• Balance of Payments stability: since the exchange rate is not determined by market forces, sudden changes in the balance of payments will be eliminated, keeping it stable instead.

Disadvantages:

• Conflict with other macroeconomic objectives: the goal to maintain a fixed exchange rate may conflict with other macroeconomic objectives when the government intervenes with its policies. For example, if it raises interest rates to remove the pressure of the currency to fall, economic growth might be adversely affected.
• Less flexibility: in a fixed exchange rate, it is difficult to respond to temporary shocks. For example, if the price of oil increases, a country which is a net oil importer will see a deterioration in the current account balance of payments. But since the country operates a fixed exchange rate, it cannot devalue the currency too much and thus cannot make an effective intervention to improve the current account.
•  Risk of overvaluation or undervaluation: it is difficult to know the right rate to fix the exchange rate at. If the rate is too high, it will make exports uncompetitive. If it is too low, it could cause inflation. It is difficult to ascertain the optimum foreign exchange rate.

Notes submitted by Lintha

Click here to go to the next topic

Click here to go to the previous topic

Click here to go back to the Economics menu