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Exchange Rates
1
Introduction
• The exchange of different
currencies facilitates
international trade. An
exchange rate is the price of
one countries’ currency in
terms of another.
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Introduction
• The foreign exchange market (FOREX) is
the market where currencies are
exchanged.
• Whilst there are different methods of
determining exchange rates, in the long
term, the forces of demand and supply will
determine the value of a currency.
• An appreciation of a currency takes place
when its value rises against other
currencies, whereas a depreciation occurs
when a currencies’ value falls against
other currencies.
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Trade Weighted Index
• The trade weighted index
(TWI) is an index which
measures changes in the
value of a country’s currency
against the currencies of its
major trading partners.
• Weights are allocated directly
according to the proportion of
trade carried out with that
country.
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Demand and Supply for a currency
• The demand for a country’s currency is determined by:
– Exports of goods and services
– Receipts of income from overseas
– Foreign investment / capital inflow
These are all credits on the balance of payments.
• The supply of a country’s currency is determined by:
– Imports of goods and services
– Payment of income to overseas
– Investment abroad / capital outflow
These are all debits in the balance of payments.
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Determining the Exchange Rate
• Countries can adopt several
means for the exchange rate to be
determined. There are three main
means:
– Free or floating exchange rate
– Managed exchange rate
– Fixed exchange rate
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Free / floating exchange rate
• As with any free market, the
price of the currency with a
floating exchange rate is
determined by the forces of
demand and supply. The
diagram on the next slide
illustrates the free market of the
Singaporean dollar.
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Free / floating exchange rate
Price of $S
in $US
S
S1
P1
P2
P3
D1
D
Quantity of $S
Increased supply (S to S1):
- Increased imports
- Increased payments of
income
- Increased capital outflow
Increased demand (D to D1):
- Increased exports
- Increased income receipts
- Increased capital inflow
Obviously D and S could also
decrease.
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Free / floating exchange rate
• The floating exchange rate
has the effect of equalising
the value of debits and
credits, meaning the balance
of payments must balance.
• However, a significant
proportion of currency
transactions are purely
speculative and hence this
theoretical idea does not
work in practice.
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Managed exchange rate
• This is very similar to a
free exchange rate and
is normally allowed to
find its own value within
a desirable range, but is
subject to official
intervention when it
moves outside that
range.
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Managed exchange rate
• In order to support the value of a
currency, the Central/Reserve
Bank would purchase the currency
using foreign exchange.
• To arrest an appreciation in the
currency, the Central/Reserve
Bank would purchase foreign
exchange using the country’s
currency.
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Fixed exchange rate
• A fixed exchange rate exists when the
value of the currency is tied to one or
more other currencies – in effect this
means that the central authority
guarantees to pay a certain rate of
exchange.
12
Fixed exchange rate
• Practically, this
reduces the full
convertibility of the
currency. The central
authority is agreeing to
make up any net
shortfall in supply and
demand to maintain
the currency’s value.
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Fixed exchange rate
• If under a fixed exchange rate the current
level is clearly inappropriate and there is
an excessive inflow or outflow of foreign
currency, then the authority may change
to a new rate. A movement to a higher
rate is called a revaluation whereas a
movement to a lower rate is known as a
devaluation.
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Assessing fixed exchange rates
• Fixed exchange rates have the
benefit of providing a stable
exchange rate which eliminates
uncertainty.
• However, the disadvantage is that net
inflows and outflows of currency will
occur because there is no
mechanism to change relative prices
and the terms of trade. The move to a
floating exchange rate should provide
the automatic balancing mechanism
in the balance of payments.
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The J-curve
• The J-curve theory states that a current account
deficit causes a depreciation of the exchange rate
but that this depreciation will worsen the current
account deficit (CAD) before it improves it.
• Depreciation reduces prices of exports in overseas
currency, and increases the prices of imports in
domestic currency. Whether this corrects the
balance of trade depends on the elasticity of
demand for exports and imports.
• Depreciation will cause the price of imports to
increase immediately but it will take longer for the
price effects on exports to take effect.
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The J-curve
+
Changes in
merchandise
trade balance
–
1
2
Time
• Depreciation
initially worsens the
trade balance
(Stage 1) and then
in Stage 2 the
deficit is reduced
and then surplus is
eventually
achieved.
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