Exchange rates

freely floating exchange rates

Exchange rates: The value at which one countries currency can be exchanged with for a foreign countries currency.

Speculators: are people who analyze and forecast future price movement trading in order to get a profit.

Freely floating exchange rate: This is an exchange rate where the value of the currency is determined by market forces (factors affecting demand and supply) within the foreign exchange market

Currency appreciation vs depreciation

Currency appreciation: increase in the value of the currency in the floating exchange rate system. 

Currency depreciation: decrease in the value of the currency in the floating exchange rate system.

Determination of exchange rates

The exchange rate is determined by people by peoples demand for the currency and the supply of the currency. This is quite similar to how price was determined in macroeconomics, and to illustrate it we use an a very similar diagram.

Who demands a countries currency?

Who supplies a countries currency?

Note: this is the opposite of what demand was

Causes of changes in exchange rate

The exchange rate is affected by changes in demand and supply of the currency.

Factors affecting exchange rate

Example - "The US increases their reserve of euros"

  1. The us increases their reserve buy selling their currency in return for the Euro.
  2. This increases supply of their currency
  3. This shifts the supply curve right, decreasing the exchange rate.

Economic consequences of exchange rate

Government intervention

Fixed exchange rates

A fixed exchange is when the government pegs the currency to the exchange rate of other countries exchange rate. Often the exchange rate chosen is the countries main competitor, thus many countries choose to peg to the USD.

Maintaining a fixed exchange rate.

The exchange is connected to the demand and supply for the countries currency, so the country must buy and sell currency in order to affect the exchange rate. This can be done through:

Devaluation vs Revaluation

Devaluation: When a countries currency is lowered relative to another countries currency. 

Revaluation: When a countries currency is raised relative to another countries currency

Showing how the exchange rate can be maintained in diagrams

In the diagrams above the bople is maintained at 2$ per bople. Importantly in the diagram a shift is shown which goes against the aim of maintaining the fixed rate and then a second shift is shown which fixes the problem.

Managed exchange rates

This is where the floating exchange rate still exists however there is a periodic government intervention to influence the exchange rate for various reasons. This allows the government to:

Comparison and evaluation of fixed and floating exchange rate systems


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