1 Exchange Rates

2 Introduction The exchange of different currencies facilitates international trade. An exchange rate is the price of one countries’ currency in terms of another.

3 Introduction The foreign exchange market (FOREX) is the market where currencies are exchanged. Whilst there are different methods of determining exchange rates, in the long term, the forces of demand and supply will determine the value of a currency. An appreciation of a currency takes place when its value rises against other currencies, whereas a depreciation occurs when a currencies’ value falls against other currencies.

4 Trade Weighted Index The trade weighted index (TWI) is an index which measures changes in the value of a country’s currency against the currencies of its major trading partners. Weights are allocated directly according to the proportion of trade carried out with that country.

5 Demand and Supply for a currency The demand for a country’s currency is determined by: –Exports of goods and services –Receipts of income from overseas –Foreign investment / capital inflow These are all credits on the balance of payments. The supply of a country’s currency is determined by: –Imports of goods and services –Payment of income to overseas –Investment abroad / capital outflow These are all debits in the balance of payments.

6 Determining the Exchange Rate Countries can adopt several means for the exchange rate to be determined. There are three main means: –Free or floating exchange rate –Managed exchange rate –Fixed exchange rate

7 Free / floating exchange rate As with any free market, the price of the currency with a floating exchange rate is determined by the forces of demand and supply. The diagram on the next slide illustrates the free market of the Singaporean dollar.

8 Free / floating exchange rate Increased supply (S to S1): -Increased imports -Increased payments of income -Increased capital outflow Increased demand (D to D1): -Increased exports -Increased income receipts -Increased capital inflow Obviously D and S could also decrease. Price of $S in $US Quantity of $S P1 P2 P3 S S1 D D1

9 Free / floating exchange rate The floating exchange rate has the effect of equalising the value of debits and credits, meaning the balance of payments must balance. However, a significant proportion of currency transactions are purely speculative and hence this theoretical idea does not work in practice.

10 Managed exchange rate This is very similar to a free exchange rate and is normally allowed to find its own value within a desirable range, but is subject to official intervention when it moves outside that range.

11 In order to support the value of a currency, the Central/Reserve Bank would purchase the currency using foreign exchange. To arrest an appreciation in the currency, the Central/Reserve Bank would purchase foreign exchange using the country’s currency. Managed exchange rate

12 A fixed exchange rate exists when the value of the currency is tied to one or more other currencies – in effect this means that the central authority guarantees to pay a certain rate of exchange. Fixed exchange rate

13 Practically, this reduces the full convertibility of the currency. The central authority is agreeing to make up any net shortfall in supply and demand to maintain the currency’s value. Fixed exchange rate

14 Fixed exchange rate If under a fixed exchange rate the current level is clearly inappropriate and there is an excessive inflow or outflow of foreign currency, then the authority may change to a new rate. A movement to a higher rate is called a revaluation whereas a movement to a lower rate is known as a devaluation.

15 Fixed exchange rates have the benefit of providing a stable exchange rate which eliminates uncertainty. However, the disadvantage is that net inflows and outflows of currency will occur because there is no mechanism to change relative prices and the terms of trade. The move to a floating exchange rate should provide the automatic balancing mechanism in the balance of payments. Assessing fixed exchange rates

16 The J-curve The J-curve theory states that a current account deficit causes a depreciation of the exchange rate but that this depreciation will worsen the current account deficit (CAD) before it improves it. Depreciation reduces prices of exports in overseas currency, and increases the prices of imports in domestic currency. Whether this corrects the balance of trade depends on the elasticity of demand for exports and imports. Depreciation will cause the price of imports to increase immediately but it will take longer for the price effects on exports to take effect.

17 Depreciation initially worsens the trade balance (Stage 1) and then in Stage 2 the deficit is reduced and then surplus is eventually achieved. The J-curve + Changes in merchandise trade balance – 12 Time

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