Foreign Exchange Basics

Foreign Exchange

• The exchange rate is the rate at which one country's currency can be exchanged for another country's currency.
• A floating exchange rate system allows the exchange rate to fluctuate based on market forces, without government or central bank intervention.
• Appreciation occurs when a currency's value increases relative to other currencies.
• Depreciation happens when a currency's value decreases relative to other currencies.
• Demand for a country's currency in the foreign exchange market is determined by the demand for its exports of goods and services, and by foreign investment in the country.
• When foreigners buy a country's exports, they must pay in the exporting country's currency, increasing demand for it.
• Supply of a country's currency in the foreign exchange market is determined by the country's imports of goods and services and by its investment in other countries.
• When the demand for a currency rises, its price goes up, making it more expensive.
• When the supply of a currency rises, its price goes down, making it less expensive.

Factors Influencing Currency Fluctuation

• Changes in Imports and Exports: An increase in exports leads to higher demand for a currency, causing its value to rise.
• Changes in Interest Rates: Higher interest rates attract foreign investors, increasing demand for a currency and causing appreciation.
• Changes in Inflation Rate: A higher inflation rate makes a country's exports less competitive, decreasing demand for its currency and leading to depreciation.
• Changes in Domestic Income: A higher domestic income relative to incomes abroad will lead to currency depreciation.
• Investment Opportunities: Positive views on a country's investment opportunities lead to appreciation.
• Global Trading Patterns: Countries with strong global trade presence experience currency appreciation.
• Changes in Relative Inflation Rates: A high inflation rate makes exports less competitive internationally, leading to depreciation.

Effects of Exchange Rate Changes

• Currency Depreciation:

  • Increases demand for exports and decreases demand for imports.
  • Improves the balance of payments.
  • Leads to higher output, employment, and economic growth.
  • May lead to inflation due to increased export demand.
  • Can result in imported inflation as imports become more expensive.

• Currency Appreciation:

  • Decreases demand for exports and increases demand for imports.
  • Worsens the balance of payments.
  • Decreases output, leading to unemployment and compromising economic growth.
  • May lead to a deflationary gap.

Consequences of Overvalued and Undervalued Currencies

• Overvalued Currency:

  • Advantages:
    • Downward pressure on inflation due to cheaper imports.
    • Encourages domestic producers to improve efficiency, becoming more competitive internationally.
  • Disadvantages:
    • Makes exports uncompetitive, hurting export industries.
    • Makes imports relatively cheaper, potentially damaging domestic industries.

• Undervalued Currency:

  • Advantages:
    • Makes exports cheaper, boosting growth and employment in export industries.
    • Makes imports expensive, diverting consumers to domestic goods and increasing employment in domestic industries.
  • Disadvantages:
    • Makes imports expensive, leading to imported inflation.
    • Can affect the general price level by increasing the cost of imported components and raw materials.

Government Intervention in Exchange Rates

• Fixed Exchange Rate:

  • The government sets and maintains the exchange rate at a specific level regardless of market forces.
  • Revaluation is an official increase in the price of a currency within a fixed exchange rate system.
  • Devaluation is an official decrease in the price of a currency within a fixed exchange rate system.

• Managed Exchange Rate:

  • The government or central bank intervenes to influence the value of the currency.
  • Examples include buying or selling currency to stabilize fluctuations.
  • A dirty float (or managed float) refers to a managed intervention with a floating exchange rate.

• Government Actions:

  • Expansionary Monetary Policy: Increases GDP and depreciates the domestic currency in a floating exchange rate system in the short run.
  • Contractionary Monetary Policy: Decreases GDP and appreciates the domestic currency in a floating exchange rate system in the short run.
  • Expansionary Fiscal Policy: Increases GDP and appreciates the domestic currency in a floating exchange rate system.
  • Contractionary Fiscal Policy: Decreases GDP and depreciates the domestic currency in a floating exchange rate system.

• Central Bank Intervention:

  • Direct Forex Interventions: The central bank buys or sells domestic currency in exchange for foreign currency.
    • To sell foreign currency and buy domestic currency, the central bank requires a stockpile of foreign currency reserves.
  • Indirect Open Market Operations: The central bank buys or sells domestic treasury bonds.
    • This affects the exchange rate through changes in the money supply and interest rates.