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Determining the Exchange Rate
Determining the Exchange Rate
An exchange rate is the value of one currency expressed in terms of another currency. It represents the amount of one currency that can be exchanged for a unit of another currency.
A free-floating exchange rate system is a type of exchange rate regime in which the value of a currency is determined by the forces of supply and demand in the foreign exchange market. In a free-floating system, a central bank or government does not intervene to fix the value of its currency against other currencies.
Under this system, the exchange rate is determined by the market forces of supply and demand for a currency. If there is more demand for a currency, its value will rise, and if there is more supply, its value will fall. This type of exchange rate regime allows for greater flexibility and can be beneficial for countries that have an open economy with a flexible exchange rate.
In the above diagrams we can see the market for Euros and Market for USD. Let's take the market for Euros first. We can see that where the demand for the Euro is equal to the supply of Euros in a foreign exchange market, a price of Euros expressed in USD is determined. This is determined as 1EUR= $1.335, meaning every Euro purchased in USD will cost $1.335.
Similarly, we can see in the market for USD, the price of USD expressed in Euro terms is determined as $1 = EUR0.749, meaning every dollar purchased will cost 0.749 Euros.
To calculate the value of 1 USD in Euros, we divide the price of 1EUR buy its USD exchange rate. In this case:
1 / 1.335 = 0.749. Therefore, $1 = EUR0.749
Appreciation of a currency
Appreciation of a currency
Currency appreciation refers to an increase in the value of a currency relative to another currency in a foreign exchange market. This means that one unit of the appreciating currency can buy more units of the other currency than before. This can be caused by either an increase in demand or decrease in supply of a currency.
For example, as seen above, $1 = EUR0.749. However, let's assume an increase in the demand for USD in the market for USD, whilst supply of USD remains constant. As a shortage of dollars is now created as Qd>Qs in the market for dollars, the price of $1 (expressed in EUR) rises from EUR0.749 to EUR0.850. This means you now need more EUR to buy that same $1 and we therefore say the USD has appreciated relative to the Euro.
Similarly, let's say there is a decrease in supply of the dollar, in the market for USD. At the old exchange rate of $1 = EUR0.749 a shortage is created as Qd>Qs. As a result, the price of $1 (expressed in EUR) rises from EUR0.749 to EUR0.850. This means you now need more EUR to buy that same $1 and we therefore say the USD has appreciated relative to the Euro.
Currency appreciation can occur due to various factors, including a country's higher interest rates compared to other countries, a strong economy, high demand for its exports, or political stability. Currency appreciation can have both positive and negative impacts on a country's economy.
We can see the impacts of the above on the price of exports and imports to the US before and after the appreciation:
Before the appreciation:
A US produced good priced at $100 in euros was priced at = $100 x 0.749 = EUR74.9
After the appreciation:
$100 now priced in Euros at = $100 x 0.850 = EUR85.0
Therefore, an appreciation of the USD has made goods priced in USD more expensive in Euro terms. This could therefore reduce the number of exports sold by US firms to consumers in the Eurozone (countries that use the euro).
Depreciation of a currency
Depreciation of a currency
Currency depreciation refers to a decrease in the value of a currency relative to another currency in a foreign exchange market. This means that one unit of the depreciating currency can buy fewer units of the other currency than before.
For example, as seen above, EUR1 = $1.335. However, let's assume an decrease in the demand for Euro in the market for Euros, whilst supply of Euros remains constant. As a surplus of euros is now created as Qs>ds in the market for Euros , the price of 1EUR (expressed in USD) decreases from $1.335 to $1.117 This means that you need less USD to buy 1EUR, therefore the EUR has depreciated relative to the USD.
Similarly, let's say there is an increase in supply of euros, in the market for euros. At the old exchange rate of EUR1 = $1.335 a surplus is created as Qs>Qd. As a result, the price of EUR1 decreases (or depreciates) from $1.335 to $1.117. This means that you need less USD to buy that same 1EUR and we therefore say the EUR has depreciated relative to the USD.
Currency depreciation can occur due to various factors, including a country's lower interest rates compared to other countries, a weak economy, low demand for its exports, or political instability. Currency depreciation can have both positive and negative impacts on a country's economy.
We can see the impacts of the above on the price of goods in Euros, as a result of the depreciation:
Before the depreciation:
A good produced in the Eurozone priced at EUR100 in USD was priced at = $100 x $1.335= $133.50
After the depreciation:
EUR100 good now priced in USD at = $100 x $1.117 = $117.50
Therefore, a depreciation of the Euro has made goods priced in euros cheaper in USD terms. This could therefore boost the number of exports sold by firms in the Eurozone to consumers in the US, whilst reducing imports into the eurozone, as imports become more expensive.
Factors that can cause a change in the demand or supply of a currency
Factors that can cause a change in the demand or supply of a currency
Foreign demand for a country’s exports
When there is an increase in foreign demand for a country's exports, this leads to an increase in demand for the country's currency, as foreign buyers need to purchase the country's currency in order to pay for the exports. This increased demand for the currency tends to increase its value relative to other currencies.
Domestic demand for imports
If demand from country X for goods from country Y increases, individuals in country X will need to sell currency of country X to demand currency of country Y to purchase the goods of country Y. Therefore this can increase the supply of country X´s currency and increase the demand for country Ys currency.
Relative interest rate changes
The relative rate of interest will cause an increase or decrease in the demand & supply of a currency. If Country Ys central bank set its interest rate at 2% but country X central bank sets it interest rate at 5%, then investors may be more tempted to save in country X where they will receive a higher rate of return (this of course is based on the assumption the real interest rates will be higher).
Relative rates of inflation
The relative rate of inflation will cause an increase or decrease in the demand or supply of a country. If country X has an inflation rate of 2% and country Y has an inflation rate of 6%, investors and individuals may wish to save and keep their money in country X as the rate of inflation is lower, hence the currency keeps its value. This will cause an increase in demand for the currency of country X and an increase in supply of currency Y.
Investment from abroad
If a country is receiving large amounts of investments from overseas firms, this can cause a currency to appreciate. This is because in order to be able to purchase FOPs and other assets in the country, those firms/individuals usually must do so in the local currency. This can cause the demand for a currency to increase.
Speculation
Speculators may buy or sell a currency based on their expectations of future exchange rates. For example, if a speculator believes that the value of a currency is going to increase in the future, they may buy the currency now, even if they don't need it immediately. This increased demand for the currency will cause its value to rise. On the other hand, if a speculator believes that the value of a currency is going to decrease in the future, they may sell the currency now, causing its value to fall.
Effects of changes in exchange rates
Effects of changes in exchange rates
An appreciation or depreciation of a country's exchange rate can have a number of different consequences on a countries Macroeconomy. The effects will be based on whether a country is reliant on exports or imports and therefore the elasticity of demand of these imports and exports. Below outlines the possible consequences (both positive & negative) of an appreciation or depreciation on:
Economics Growth
Inflation
Unemployment
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