Exchange rates
Payments for imports and exports and for all other international transactions requires the
exchange of national currencies. The exchange rate is the price of a currency in terms
of another currency or currencies. Currencies are exchanged on the foreign exchange
market (FOREX). Forex is the world’s largest financial market. It consists of all those
people, organizations and governments willing and able to buy or sell national currencies.
Like any commodity, currencies are traded on a market and the equilibrium price of a
currency (or its exchange rate) is set by market _____________ and __________.
What causes an exchange rate to appreciate?
The diagram below shows an APPRECIATION of the USD. An appreciation is when
the value of a currency rises against another currency. This has been brought about
by an increase in the demand for USD.
The FOREX market for US$ in terms of €
Supply of $.
Price of $ in terns of
0.9
0.8
€
D2
D1 for $
0 Q1 Q2 Quantity of $
The demand for the US$ will increase leading to an appreciation if:
There is greater demand for American ____________ overseas – these need to be
paid for in US $.
Foreign firms invest in the American economy- for example, if Toyota builds a
new car plant in Texas.
People/firms believe that the US$ will rise in value and therefore they purchase it
in the hope of making money. These people are known as ______________
High interest rates offered in US banks relative to banks in other countries- this
attracts _______________ from overseas customers who will buy the US$
(demand the dollar)
There is a balance of trade ___________
What does an appreciation mean?
Look carefully at the above diagram, before the appreciation $1 could buy you €_______,
but after the appreciation $1 will buy you €______. This will make imports into the US
cheaper than before as US consumers have to give up fewer dollars to buy Italian cheese
or French wine. But the appreciation will also cause the price of US exports to rise.
A depreciation of an exchange rate
Pri The FOREX market for £ in terms of US $
ce Supply of £
of S2
£
in
ter
ns
of
1.65
1.50
D1 for £
0 Q1 Q2 Quantity of £
The above diagram shows an increase in the supply of £ on the FOREX. The effect of
this is to cause a DEPRECIATION of the £ - the value of the currency has fallen in
terms of another currency (or currencies). This will inevitably make the price of
imports into the UK more _______________ in terms of their price in Pounds.
What causes an exchange rate to depreciate?
The supply of a currency (the Pound) will increase, causing the Pound to depreciate if:
More goods and services are imported into the UK (domestic consumers and
firms sell £ to finance their purchase of imported goods or when buying foreign
services)
Speculators sell the £ for another currency if they think the value of the Pound
will ________________
If there is a balance of trade _____________
Other countries’ interest rates rise (compared to Britain’s), making it more
attractive to save overseas rather than in British financial institutions
Correcting a current account deficit
1. Do nothing- the lower exchange rate will fix it
The immediate effect of depreciation is to make exports cheaper in terms of foreign
currency, while imports become more expensive in terms of the home currency.
Example: A pair of Doc Marten shoes (British product) cost £30 in the UK. A Ford
Mustang (American product) costs $30,000 in US. Doc Martens are exported to
USA and Ford Mustangs exported to UK. The British government wants to correct
a trade deficit with the US so it allows the Pound to depreciate.
Exchange rate Before depreciation After depreciation
£1 = $2 £1 = $1.80
Price of Doc Martens in USA
Price of Ford Mustang in UK
A lower exchange rate should cause imports into the UK to become relatively more
_____________ leading to fewer _________ from the U.S. On the other hand, UK
exports become ___________ and the UK should be able to export more goods and
services.
2. Import controls/protectionism
There are a variety of methods, including for example ________ and ________, which
can be used to limit imports and direct demand to home produced goods and services.
