Foreign Exchange Rates (Forex)
- An exchange rate is the price of one currency in terms of another e.g. £1 = €1.18
- International currencies are essentially products that can be bought & sold on the foreign exchange market (forex)
- International currencies are essentially products that can be bought & sold on the foreign exchange market (forex)
- The Central Bank of a country controls the exchange rate system that is used in determining the value of a nation's currency
- Two of the main exchange rate systems are
- A floating exchange rate
- A fixed exchange rate
1. A Floating Exchange Rate System
- Different currencies can be bought & sold, just like any other product
- The forces of demand & supply determine the rate at which one currency exchanges for another
- As with any market, if there is excess demand for the currency on the forex market, then prices rise (the currency appreciates)
- If there is an excess supply of the currency on the forex market, then prices fall (the currency depreciates)
The relationship between the US$ & the Euro shows that as Europeans demand the $ it appreciates but by supplying their own currency it depreciates
Diagram Analysis
- The Euro/US$ market is shown by two market diagrams - one for the USD market on the left & one for the Euro market on the right
- The initial exchange rate equilibrium is found at P1Q1 in both markets
- When Europeans visit the USA, they demand US$ & supply Euros
- The increased demand for the US$ shifts the demand curve to the right which results in the value of the $ appreciating from P1 → P2 in the USD market & a new market equilibrium forms at P2Q2
- The increased supply of the Euro shifts the supply curve to the right which results in the value of the Euro depreciating from P1 → P2 & a new market equilibrium forms at P2Q2
2. A Fixed Exchange Rate System
- A system in which the country’s Central Bank intervenes in the currency market to fix (peg) the exchange rate in relation to another currency e.g US$
- When they want their currency to appreciate, they buy it on forex markets using their foreign reserves, thus increasing its demand
- When they want their currency to depreciate, they sell it on forex markets, thus increasing its supply
- Sometimes the peg is at parity e.g. 1 Brunei Dollar = 1 Singapore Dollar
- Often the peg is not at parity e.g. Hong Kong has pegged its currency to the US$ at a rate of HK$ 7.75 = US$ 1
- A revaluation occurs if the Central Bank decides to change the peg & increase the strength of its currency
- A devaluation occurs if the Central Bank decides to change the peg & decrease the strength of its currency