6.4 Exchange Rate

Chapter 6.4 – Exchange Rates

6.4.1 Definition of Exchange Rate

An exchange rate is the rate at which one currency can be exchanged for another. It reflects the price of one currency in terms of another and is crucial in international trade and finance.

• Nominal Exchange Rate: The number of units of foreign currency one can get with one unit of domestic currency. For example, if £1 = $1.30, this is the nominal exchange rate.

• Real Exchange Rate: Adjusts the nominal rate for differences in price levels between countries. It shows the purchasing power of one currency against another.

• Bilateral Exchange Rate: The rate between two currencies.

• Effective Exchange Rate (EER): A weighted average of a country’s currency relative to an index or basket of other major currencies.

• Real Effective Exchange Rate (REER): Adjusts the EER for inflation differentials between countries.

6.4.2 Determination of a Floating Exchange Rate

In a floating exchange rate system, the value of a currency is determined by the forces of demand and supply in the foreign exchange market, with no direct government intervention.

Demand for a Currency

Arises from:

• Exports of goods and services

• Foreign investment in domestic assets (FDI and portfolio investment)

• Interest rate differentials (high domestic interest rates attract foreign capital)

• Speculation that the currency will appreciate

• Inflows of remittances

Supply of a Currency

Arises from:

• Imports of goods and services

• Investment abroad by domestic residents

• Travel and remittances sent overseas

• Speculation that the currency will depreciate

Equilibrium Exchange Rate

The exchange rate at which the quantity of currency demanded equals the quantity supplied. Any imbalance leads to appreciation or depreciation of the currency.

Factors Affecting Demand and Supply of Currency

• Interest rate changes (higher interest rates attract investment)

• Inflation differentials (high inflation makes exports less competitive)

• Economic performance and confidence

• Political stability

• Central bank policies (indirect influence even in floating systems)

6.4.3 Distinction Between Depreciation and Appreciation of a Floating Exchange Rate

Depreciation

• A fall in the value of a currency in a floating exchange rate system.

• Occurs when supply of the currency increases or demand decreases.

• Example: If £1 = $1.30 becomes £1 = $1.10, the pound has depreciated.

Effects of Depreciation:

• Exports become cheaper to foreign buyers.

• Imports become more expensive for domestic consumers.

• May improve the trade balance if the Marshall-Lerner condition is met.

• Can lead to imported inflation.

Appreciation

• A rise in the value of a currency in a floating exchange rate system.

• Occurs when demand increases or supply decreases.

• Example: If £1 = $1.30 becomes £1 = $1.50, the pound has appreciated.

Effects of Appreciation:

• Exports become more expensive.

• Imports become cheaper.

• Can worsen the trade balance.

• Helps reduce inflationary pressures.

6.4.4 Causes of Changes in a Floating Exchange Rate: Demand and Supply of the Currency

The exchange rate fluctuates due to changes in demand and supply of the currency, which in turn are influenced by:

Demand-Side Factors

• Increased Exports: Foreign buyers need domestic currency, increasing demand.

• Higher Interest Rates: Attract “hot money” flows into the country.

• Foreign Direct Investment (FDI): Investors need to convert foreign currency into domestic currency.

• Speculation: If traders expect a currency to strengthen, they buy more of it, increasing demand.

• Tourism: More foreign tourists visiting a country increases demand for its currency.

Supply-Side Factors

• Higher Imports: Domestic buyers convert local currency into foreign currency, increasing supply.

• Investment Abroad: Outflows of capital increase currency supply in the forex market.

• Speculation: If traders expect a currency to weaken, they sell it, increasing supply.

• Debt Repayment in Foreign Currency: Domestic residents need foreign currency, selling their own currency to acquire it. 

6.4.5 AD/AS Analysis of the Impact of Exchange Rate Changes on the Domestic Economy

Using the Aggregate Demand (AD) and Aggregate Supply (AS) model, we can analyze how changes in exchange rates affect macroeconomic variables:

Depreciation of Currency

1. Net Exports Increase:

• • Exports become cheaper and imports more expensive.

  • Improves current account balance (assuming Marshall-Lerner condition is satisfied).

2. AD Curve Shifts Rightward:

• Increase in net exports raises overall demand in the economy.

3. Effects on Macroeconomic Variables:

• Real GDP Increases: Higher demand for goods and services.

• Price Level Rises: Demand-pull inflation.

• Employment Increases: More production requires more labor.

4. J-Curve Effect:

• Initially, trade balance worsens due to existing contracts and inelastic demand.

• Over time, as quantities respond, the trade balance improves.

Appreciation of Currency

1. Net Exports Decrease:

• • Exports become more expensive; imports cheaper.

  • Worsens the trade balance.

2. AD Curve Shifts Leftward:

• Reduced demand for domestic goods and services.

3. Effects on Macroeconomic Variables:

• Real GDP Falls: Lower output demand.

• Price Level Falls: Disinflationary or deflationary effect.

• Employment Falls: Decrease in production leads to job cuts.

4. Reverse J-Curve Effect:

• Short-run improvement in trade balance (if imports fall fast).

• Long-run worsening as exports shrink and import volumes grow.

Marshall-Lerner Condition

Depreciation improves trade balance only if the sum of price elasticities of exports and imports is greater than 1. Otherwise, the trade balance could worsen.

Conclusion

Exchange rates are a vital tool in macroeconomic management. Their fluctuations, especially under floating systems, significantly influence trade flows, inflation, national income, and employment. Understanding how demand and supply interact in currency markets, and applying AD/AS analysis, allows economists and policymakers to anticipate and respond to the economic consequences of exchange rate movements.