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Economic Issue
of the Day
Philippine Institute
for Development Studies
S u r i a n s a m g a Pa g -a a ral
Pangkaunlaran ng Pilipinas
Vo l . V I N o . 3 ( A p r i l 2 0 0 6 )
Exchange rate
E
xchange rates reflect the price of one currency in terms
of another. This means that if the current rate is P52=$1,
a person holding $1 can have it exchanged for P52 or
equivalently, one needs P52 to buy $1.
Why is it important?
Exchange rates play a crucial role in international trade because
they allow one to compare the prices of goods and services in
different countries. If the exchange rate stands at P52-$1, a kilo
of Gouda cheese that sells $20 is approximately P1,040 in the
domestic market. A change in the peso/dollar rate can alter the
price of Gouda cheese assuming its dollar price remains the same.
Suppose the exchange rate changes to P50-$1, then the imported
cheese would now cost P1,000.
Changes in exchange rates are described as depreciations
or appreciations. A depreciation of the Philippine peso against
the US dollar means the value of the peso fell relative to the
dollar. In terms of exchange rates, this means from P52-$1 to
P54-$1. An appreciation of the peso is a rise in the value relative
to the dollar, i.e., from P52-$1 to P50-$1. From the example
above, one can conclude that an appreciation (depreciation) of
the peso makes imported products cheaper (more expensive) in
the Philippines. Conversely, a depreciation favors exporters and
local producers with import substitutes since they can earn extra
profit without adjusting production cost.
How is the exchange rate determined?
Exchange rates are determined by the demand and supply for
foreign exchange from the households, firms, and financial
institutions that buy and sell foreign currencies to make
international payments. The market by which international
currency trading takes place is called the foreign exchange
market. The users of foreign currency (demand side) are weighed
against the sources of dollars (supply side) and their interaction
determines the rate. Some of the users are the importers and
corporations with international transactions while the sources
are the exporters, foreign creditors, and the overseas contract
workers. If the users of dollar outweigh the sources, this means
more people are demanding dollars, thereby making it a more
valuable currency over the peso. In terms of currency pricing,
this will put pressure on the dollar to appreciate relative to the
peso. An appreciation of the dollar is synonymous with a
depreciation of the peso. When the peso is appreciating, this
means there is a strong demand for peso over the dollar. The
country’s balance of payments (BOP) keeps a fairly good track
of the uses and sources of dollars (Table 1).
Table 1. Balance of payments (in US$ million)
2004
1. Current account
Goods and services
Export
Import
Income
Receipts
Payments
2. Capital and financial account
Capital
Receipts
Payments
Financial
Direct investment
Portfolio investment
Financial derivatives
Others
3. Net unclassified items
4. Overall position
2005
as of Sept.
584
(6,109)
31,281
(37,390)
(184)
2,763
(2,947)
(407)
(13)
4
(17)
(394)
(39)
(902)
(20)
567
(353)
(176)
1,205
(7,049)
32,595
(39,644)
(377)
2,997
(3,374)
2,249
2
16
(14)
2,247
756
3,178
(8)
(1,679)
(724)
2,730
% Change
106.3
4.2
6.0
2,038.5
452.3
60.0
(396.1)
105.1
1,651.1
Source: Bangko Sentral ng Pilipinas
Note: Items in italics are outflow, figures in parenthesis are negative.
Economic Issue of the Day
Exchange rate
Vo l . V I N o . 3 ( A p r i l 2 0 0 6 )
7.50
6.50
5.50
4.50
2004
2005
3.50
2.50
1.50
When does the Central Bank come in?
De
c
No
v
ct
O
Se
p
Au
g
Ju
l
Ju
n
M
ay
Ap
r
M
(0.50)
ar
0.50
Fe
b
While the BOP records the country’s demand and
supply of dollars, regular trading is conducted in
the foreign exchange market. In this market, the
dollar is regarded as an asset. This means the
principles governing the behavior of other asset
prices like stock certificates are also applicable
for exchange rates. Generally, prices of asset
today are determined by what it can buy in the
future; hence, expectations play a vital role in
asset pricing. A person holding the dollar will
either hang on to it or unload it, depending on
(a) his needs for the dollar, and (b) what he
expects the future price will be. Any information
concerning future currency values, or news
affecting people’s expectations, can cause the
exchange rate to fluctuate.
Figure 1. Volatility of the peso/dollar
Ja
n
Why does the rate change every day?
The Bangko Sentral ng Pilipinas, the country’s highest monetary
authority, is responsible for monitoring and stabilizing peso
fluctuations. Policy initiatives originate from the monetary
managers in an attempt to arrest large peso fluctuations which
could send detrimental signals to the investors and local
consumers. Fluctuations, measured in terms of volatility, can be
tamed through either interest rate changes or money supply
movements. Both monetary policy tools have their strengths and
weaknesses, and intended effects. A close and deep
understanding of the economic forces is necessary to determine
the appropriate monetary policy. Figure 1 shows that the
exchange rates in 2005 were more volatile compared to the
previous year. This means that the rates in 2005 were deviating
more, and in large degree, from the average level. This implies
an unstable peso movement which needed policy action from
the monetary managers.
machineries are imported favoring a stronger peso, electronic
and garment manufacturers, together with overseas contract
workers, would vote for a depreciated peso. Sadly, a country
cannot have two exchange rates at the same time. Market forces
would eventually settle for one price.
A number of Filipinos associate a stronger peso with the
strength of the economy. While it is true that the peso carries
the purchasing power of a consumer, it does not exactly translate
to the overall performance of the Philippines. It must be kept in
mind that the exchange rate is the valuation of the local currency
against another currency. It is not analogous to comparing
country performances. Case in point is China where the yuan is
intentionally kept at a low level relative to the US dollar, yet its
economy is considered to be a powerhouse. The exchange rate
as well as stock prices and Treasury Bill rates are used as crude
measures of performance but are highly influenced by perceptions
and expectations, rather than fundamentals. ❋
Is a stronger peso good for the economy?
Reference
This is one controversial question that does not have a ready
textbook answer. While important commodities like oil and heavy
Mishkin, F. 2003. Economics of money, banking and financial
markets. 6th ed. Boston: Addison Wesley.
The Economic Issue of the Day is one of a series of PIDS efforts to help in enlightening the public and other interested parties on the concepts
behind certain economic issues. This dissemination outlet aims to define and explain, in simple and easy-to-understand terms, basic concepts as they
relate to current and everyday economics-related matters.
This Issue was written by Ma. Teresa S. Dueñas-Caparas, Supervising Research Specialist at the Institute. She benefited from the comments of Dr.
Erlinda M. Medalla, Senior Research Fellow.
The views expressed are those of the author(s) and do not necessarily reflect those of PIDS. ❋
Philippine Institute for Development Studies
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