Exchange rate
Foreign Exchange
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International transactions involves the use of different national currencies
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Foregin exchanges are done in the Foreign exchange market, and it is made up by the demand & supply of currencies
Demand for a currency = Supply of another currency
*When you demand for a certain currency, you must sell (supply) a currency in the foregin exchange market
Exchange Rate
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Mechanism establishing the value of each currency (like price mechanism in mirco)
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A value of a currency is always determined by comparing the value relative to another currency
Four kinds of exchange rate system
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Freely floating exchange rate system
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Fixed Exchange Rate system
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Managed Exchange rate system
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Pegging Exchange rate system
Freely floating exchange rate system
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Exchange rates are determined by market forces (supply & demand)
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No government intervention
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Equilibrium exchange rate, when Qd (quantity of a currency demanded) = Qs (quantity of a currency supplied)
Fig X. Diagram of a freely floating exchange rate system
Changes in Exchange rate: Appreciation & Depreciation
Appreciation
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An increase in the value of a currency in a floating exchange rate system
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Cause by either increase in D or decrease in S
Depreciation
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A decreased in the value of a currency in a floating exchange rate system
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Cause by either decrease in D or increase in S
Causes of changes in exchange rates
*Vice versaaaaaa!!
Consequence when ER changes
Fixed exchange rate system
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Exchange rates are fixed by central bank of each country, and are not permitted to change in response to changes in currency supply and demand
Intervention to maintain fixed exchange rate
It's like government policy, when AD/SRAS changes, how can we adjust it back to the original eq?
Ways to deal with a downward currency’s value:
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Increased in interest rates
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Borrowing from abroad
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Efforts to limit imports
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Imposing exchange controls
Revaluation & Devaluation
Devaluation (like appreciation)
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If a currency has a higher value that can be maintained through intervention, the government may change the fixed rate to a new and higher value
Revaluation (like depreciation)
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If a currency has a low value that can be maintained through intervention, the government may change the fixed rate to a new and lower value
Managed exchange rates
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A system that an exchange rate is mainly determined through market forces, but with periodic intervention by central banks smooth out abrupt fluctuations
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Intervention rakes mainly in the form of selling and buying reserves
Overvalued currency & Undervalued currency
Overvalued
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One that has a value that is too high relative to its equilibrium free market value, which its exchange rate has been set at a higher level than the equilibrium free market exchange rate
Undervalued
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One that has a value that is too low relative to its equilibrium free market value, which its exchange rate has been set at a lower level than the equilibrium free market exchange rate
Pegged exchange rates
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To make a currency fixed in relation to another currency