6.3. Foreign exchange rates
- Syllabus
- 0455–2027–2028
- Topic
- 6.3
- Level
- —
Learning objectives
6.3.1Definition of foreign exchange rate• Definition of foreign exchange rate6.3.2Reasons for buying and selling foreign currencies• trade in goods and services• speculation• government intervention in currency markets• payment of profit, interest and dividends between countries• workers’ remittances• investment in capital goods between countries6.3.3Determination of foreign exchange rate in foreign exchange market• definitions of floating exchange rate, appreciation and depreciation• the demand for and supply of a currency• the determination of the equilibrium foreign exchange rate• causes of foreign exchange rate fluctuations• changes in demand for exports and imports• changes in the interest rate• speculation6.3.4Consequences of changes in foreign exchange rates• effects of changes in foreign exchange rates on prices and demand for exports and imports
Read a foreign exchange rate
A foreign exchange rate is the price of one currency in terms of another currency. It tells you how much of the quoted currency can be exchanged for one unit of the base currency.
If £1 = US1.25,onepoundexchangesfor1.25USdollars.Atthatsamemoment,US1 exchanges for £0.80 because 1 ÷ 1.25 = 0.80.
Always read the direction of the quotation before comparing rates. A larger number means the base currency buys more of the quoted currency; reversing the quotation reverses the number.
Why currencies are bought and sold
Every foreign-exchange transaction buys one currency and sells another. The currency needed for the payment is demanded; the currency offered in exchange is supplied.
| Reason | Why currency is exchanged |
|---|---|
| trade in goods and services | importers buy the seller's currency to pay for foreign products |
| speculation | traders buy a currency they expect to appreciate and may sell one they expect to depreciate |
| government intervention | a central bank buys or sells currencies to influence the exchange rate or reserves |
| profit, interest and dividends | cross-border earnings are converted before being paid to owners or lenders |
| workers' remittances | workers convert earnings when sending money to people in another country |
| investment in capital goods | firms and investors obtain foreign currency to purchase overseas capital or establish production abroad |
Do not label a flow as only a purchase or only a sale. Buying foreign currency to import machinery simultaneously supplies the importer's domestic currency.
How a floating exchange rate is determined
In a floating exchange-rate system, market demand and supply determine a currency's price. Equilibrium is the exchange rate at which the quantity of that currency demanded equals the quantity supplied.
An appreciation is a rise in a currency's value, so one unit buys more foreign currency. A depreciation is a fall in its value, so one unit buys less foreign currency.
| Change, other things equal | Foreign-exchange-market shift | Likely result |
|---|---|---|
| foreigners demand more of the country's exports | demand for its currency rises | appreciation |
| residents demand more imports | supply of its currency rises to buy foreign currency | depreciation |
| the country's interest rate rises relative to rates abroad | foreign financial inflows may raise currency demand | appreciation |
| speculators expect the currency to appreciate | they buy it now, raising demand | appreciation pressure |
| speculators expect the currency to depreciate | they sell it now, raising supply | depreciation pressure |
A demand increase or supply decrease creates excess demand at the old rate, bidding the currency up. A demand decrease or supply increase creates excess supply, pushing it down until a new equilibrium is reached.
State which currency's market you are analysing. More imports by the home country increase the supply of the home currency, not its demand, because residents sell it to obtain foreign currency.
Trace exchange-rate effects on trade
An exchange-rate change alters the domestic-currency price of imports and the foreign-currency price of exports. Those price changes then affect quantities demanded.
| Change in home currency | Export price for foreign buyers | Import price for home buyers | Likely demand response |
|---|---|---|---|
| appreciation | rises | falls | export demand falls; import demand rises |
| depreciation | falls | rises | export demand rises; import demand falls |
Depreciation: home currency buys less foreign currency → imported products and inputs cost more at home, while home exports become cheaper abroad → buyers tend to switch towards home output. Appreciation reverses these price signals.
The size and timing of the demand response depend on price elasticity, whether firms pass the exchange-rate change into prices, the availability of substitutes, contracts and production capacity.
A depreciation does not guarantee that export revenue rises or import spending falls. Quantity demanded must respond enough to the changed prices, and adjustment can take time.