1. Economics - Notes for Teachers
Exchange Rates
Exchange Rates
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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. Managed exchange rate
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.

12. Fixed exchange rate
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.

13. Fixed exchange rate
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.

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. Assessing fixed exchange rates
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.

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

18. Economics - Notes for Teachers
Exchange Rates
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