Exchange Rate Definition Example Essay

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INTRODUCTION
The foreign exchange market is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies. (wiki.org)
The exchange rate is the price of a unit of foreign currency in terms of the domestic currency. In the Philippines, for instance, the exchange rate is conventionally expressed as the value of one US dollar in peso equivalent.
The value of any particular currency is determined by market forces based on trade, investment, tourism, and…show more content…

(3) exchange rate movements can affect the country’s external sector through its impact on foreign trade. An appreciation of the peso, for instance, could lower the price competitiveness of our exports versus the products of those competitor countries whose currencies have not changed in value. (4) the exchange rate affects the cost of servicing (principal and interest payments) on the country’s foreign debt. A peso appreciation reduces the amount of pesos needed to buy foreign exchange to pay interest and maturing obligations.
Foreign exchange policy in the Philippines has evolved from a pegged system to a floating rate regime over the last 50 years. The period of pegged exchange rate regime witnessed an extensive use of a myriad of administrative rules that were set to restrict access of Philippine residents and corporations to foreign currency. From 1949 to early 1970, foreign exchange policy was used to promote exports industries, to limit imports, and to try to change the orientation of the Philippine economy from agricultural to agro-industrial. Even after the floating rate system was adopted in 1970, it was not until late 1984 that the central bank stopped announcing a guiding rate and imposing a trading band. Moreover, it was a decade hence yet before the watershed set of reforms was issued. In 1993, the BSP liberalized capital flows and implemented a comprehensive set of foreign exchange market

  • The exchange rate is the rate at which one currency trades against another on the foreign exchange market
  • If the present exchange rate is £1=$1.42, this means that to go to America you would get $142 for £100. Similarly, if an American came to the UK, he would have to pay $142 to get £100. Although in real life, the dealer would make a profit.
  • Currencies are being continuously traded on the foreign exchange markets, with the prices constantly changing as dealers adjust to changes in supply and demand
  • Currencies will also undergo long-term changes depending on the state of the comparative countries. E.G. in the 1920s the £ was worth $4.50

Value of the Pound to Dollar 2006-2016. In mid-2008, there was a sharp depreciation in the value of the Pound because the UK was hit very hard by the credit crunch.  The Pound also dropped after the Brexit vote in June 2016 because markets were less optimistic about the long-term fortunes of the UK economy outside the EU.

 Definitions

  • Exchange rate index  This gives a measure of a currency against a trade-weighted basket of currencies. It is expressed as an index, where the value of the index will be 100 in the base year. The weight given to each currency depends upon the proportion of transactions done with the country. For example, in the Sterling exchange rate index, the highest weighting will be given to the Euro and then the dollar.
  • Real Exchange Rate. This is the exchange rate after being adjusted for the effects of inflation, it, therefore, more accurately reflects the purchasing power of a currency.
  • Floating exchange rate – When the value of the currency is determined by market forces – supply and demand for currency
  • Fixed exchange rate – where the government seeks to keep the value of a currency at a certain level compared to other currencies. See: Fixed Exchange Rates

Determination of exchange rates using supply and demand diagram

In this example, a rise in demand for Pound Sterling has led to an increase in the value of the £ to $
from £1 = $1.50 to £1 = $1.70

Factors influencing exchange rates

  • Interest rates  – higher interest rates encourage hot money flows and demand for currency. This causes an appreciation.
  • Economic growth – higher economic growth will tend to cause an appreciation in the currency, this is because markets expect higher interest rates – when growth is rapid.
  • Inflation – higher inflation makes exports less competitive and reduces demand for currency. This causes a depreciation.
  • Confidence in the economy/currency.
  • Current account deficit/surplus. A large current account deficit is more likely to cause a depreciation in the value of the currency because money is leaving the economy to buy imports.
  • See more detail at Factors influencing exchange rates

Appreciation of exchange rate

If the Pound Sterling appreciates in value, the effects will include:

  • UK exports more expensive abroad – leading to lower demand.
  • Imports into the UK will be cheaper, increasing demand for imports
  • An appreciation will tend to reduce inflation,
  • Lower economic growth – due to reduced demand for exports.
  • Worsening of the current account deficit (because imports are cheaper and quantity of imports rises, but exports are more expensive and quantity falls)
  • Strong Pound = Imports Cheaper, Exports Dearer. SPICED

Depreciation / Devaluation

If the Pound devalues then we will see:

  • UK exports become more competitive, increasing demand for exports
  • Imports become more expensive, leading to lower demand for imports
  • A depreciation will tend to increase economic growth but also cause inflation.
  • Does a devaluation help an economy?

Evaluation of exchange rates

Elasticity of demand. If there is a depreciation in the exchange rate, exports are cheaper, but the amount quantity increases depend on the elasticity of demand. If demand is price inelastic, then a depreciation will have a limited impact in increasing demand and improving economic growth. If demand for exports is elastic, then there will be a big boost to exports.

Time Lag. In the short term, demand for exports is often inelastic but becomes more price elastic over time.

Reasons for depreciation/appreciation. Often it is most successful economies who see appreciation. The currency appreciates because there is more demand for their exports. Therefore, in this case, a depreciation won’t cause a fall in economic growth – only limit the growth rate. If the currency appreciates due to speculation, during a period of weak economic growth, then the negative effect on growth may be more pronounced.

 

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