Exchange Rates-1

EXCHANGE RATES
1
Definition
Exchange rate is the number of
units of foreign currency that
each unit of domestic currency
will buy.
2
Importance of Exchange Rates
Domestic purchases are made with local currency.
Purchasing goods abroad requires converting
local currency to the foreign currency
Exchange rates are set in the foreign exchange
market.
Rates are determined by supply and demand
Changes in exchange rates have significant
effect on most economies.
3
Changes in exchange rates
Appreciation: is an increase in the value
of a currency relative to the other.
Depreciation: is a decrease in the value
of a currency relative to the other.
4
Depreciation and Appreciation
A depreciated currency means that imports are more
expensive and exports are less expensive.
A depreciated currency lowers the price of exports relative to the
price of imports.
An appreciated currency means that imports are less

expensive and exports are more expensive.
An appreciated currency raises the price of exports relative to the
price of imports.
Appreciation of the Kwacha against the Dollar means

depreciation of the Dollar against the Kwacha.
How Exchange Rates are
Determined
The nominal exchange rate enom is the
value of a currency, say the dollar.
The value of the dollar is determined by
supply and demand in the foreign
exchange market.
Foreign Exchange Markets
The set of markets where foreign currencies and other assets
are exchanged for domestic ones
Different institutions buy and sell deposits of currencies or other
assets for investment purposes.
The main centers of foreign exchange trade are: London, New York,
Tokyo, Frankfurt, and Singapore.
April 2010: The daily volume of foreign exchange

transactions was $4.0 trillion
In 1989 it was only $600 billion.
Foreign Exchange Markets – The
Participants
1. Commercial banks and other depository institutions:
transactions involve buying/selling of deposits in different
currencies for investment purposes.
2. Non-bank financial institutions (mutual funds, hedge
funds, securities firms, insurance companies, pension funds)
may buy/sell foreign assets for investment.
3. Non-financial businesses (corporations) conduct foreign
currency transactions to buy/sell goods, services and assets.
4. Central banks: conduct official international reserves
transactions.
Spot Rates and Forward Rates
Spot rates are exchange rates for currency exchanges “on
the spot,” or when trading is executed in the present.
Forward rates are exchange rates for currency exchanges
that will occur at a future (“forward”) date.
Forward dates are typically 30, 90, 180, or 360 days in the future.
Rates are negotiated between two parties in the present, but the
exchange occurs in the future.
Exchange Rate Strategies
The foreign exchange market is the market
on which currencies are traded.
A flexible exchange rate is an exchange rate
whose value is not officially fixed, but varies
according to the supply and demand for the
currency in the Forex market.
A fixed exchange rate is an exchange rate set
by official government policy.
11
Flexible Exchange Rate
in the Short Run Exchange rates are set by supply
and demand in the foreign exchange market
Dollars are demanded by foreigners who seek to
purchase U.S. goods or financial assets
–Number of dollars foreigners seek to buy
Dollars are supplied by U.S. residents who need
foreign currency to buy foreign goods or financial
assets
–Not the same as the money supply set by the CB
–Number of dollars offered in exchange for other currencies
12
Fixed Exchange Rates
Most large industrial countries use a flexible exchange rate
–Small and developing countries may use a fixed exchange rate
Fixed exchange rates greatly reduce the effectiveness of
monetary policy as a stabilization tool
To establish a fixed exchange rate system, the government
states the value of its currency in terms of a major currency
–May use an average of the currencies of its major trading partners
Government attempts to maintain the fixed exchange rate at
its existing level
The government may change the value of its currency in
response to market events
13
Exchange rate and monetary policy
Flexible exchange rates strengthen the effectiveness of
monetary policy for stabilization
Fixed rates require the central bank to choose between
defending the currency and stabilizing the economy
Fixed rates can be beneficial for small economies
–Argentina fought hyperinflation by valuing its peso on par with the
dollar
Inflation quickly decreased and stayed stable for more than 10 years
Fixed exchange system broke down because unsound domestic
policies created fears that Argentina would default on international
loans
14
Real Exchange rate
In the short run, domestic prices of goods are fixed
–In the long run, this assumption is relaxed
The real exchange rate is the price of the average
domestic good relative to the price of the average foreign
good when prices are expressed in a common currency
The nominal exchange rate, e, is the number of units of
foreign currency per dollar
–
15
16
Inflation Rates
Changes in market inflation cause changes in currency
exchange rates.
A country with a lower inflation rate than another's will
see an appreciation in the value of its currency. The
prices of goods and services increase at a slower rate
where the inflation is low.
A country with a consistently lower inflation rate
exhibits a rising currency value while a country with
higher inflation typically sees depreciation in its
currency and is usually accompanied by higher interest
rates.
17
Terms of Trade
A trade deficit also can cause exchange rates to
change. The terms of trade is the ratio of export
prices to import prices.
A country's terms of trade improves if its exports
prices rise at a greater rate than its imports prices.
This results in higher revenue, which causes a
higher demand for the country's currency and an
increase in its currency's value. This results in an
appreciation of exchange rate.
18
Output
When domestic output (income) rises the
demand for imports increases and net
exports must fall.
The domestic currency depreciates, the
exchange rate falls.
19
Interest Rates
If the domestic country’s real interest rate rises, other
factors held constant, the country’s real and financial
assets are more attractive for investment.
The demand for domestic currency increases and the
exchange rate appreciates
Government Debt
A country with government debt is less likely to
acquire foreign capital, leading to inflation. Foreign
investors will sell their bonds in the open market. As a
result, a decrease in the value of its exchange rate will
follow.
20
Fixing the Exchange Rate
In a fixed-exchange-rate system, the

value of the nominal exchange rate is
officially set.
An overvalued exchange rate is a
situation when an exchange rate (enom)
is higher than its fundamental value
(e1nom).
Overvalued Exchange Rate
In a situation of an overvalued
exchange rate a government can:
devalue its nominal fixed exchange rate;
restrict international transactions;
buy back its currency in foreign exchange
market.
Overvalued Exchange Rate
(continued)
To support the domestic currency the
central bank must use the reserves that
correspond to the country’s balance of
payment deficit.
It cannot do that forever because the
amount of reserves is limited.
A Speculative Run
An attempt to support an overvalued

currency can be ended by a speculative
run – to avoid losses, financial investors
frantically sell assets denominated in
the overvalued currency.
How to Support an Overvalued
Currency
To support an overvalued currency a
country could:
impose strong restrictions on international
trade and finance;
devalue its currency;
make a policy change to raise the
fundamental value of the exchange rate
(use monetary policy).
Undervalued Exchange Rate
An undervalued exchange rate exists if

the officially fixed value is lower than
the fundamental value of the exchange
rate.
An undervalued exchange rate could be
maintained indefinitely if a country
trading partners would not lose their
reserves.
Fixed versus Flexible Exchange
Rates
Benefits of fixed-exchange-rate
systems:
less costly trade in goods between
countries, i.e. lower transaction cost;
promoted monetary policy discipline.
The downside is inability of a country to
use its monetary policy to deal with
recessions.

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EXCHANGE RATES

An appreciated currency means that imports are less

Appreciation of the Kwacha against the Dollar means

April 2010: The daily volume of foreign exchange

In a fixed-exchange-rate system, the

An attempt to support an overvalued

An undervalued exchange rate exists if

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