Exchange rate

1. EXCHANGE RATES
Presented to: Dr. Ummara Saher
Presented by: Rafia Junaid 2021-1501
Nimra Aijaz 2021-1504
Muqaddas Iftikhar 2021-1538

2. Exchange Rates
•Definitions
•An exchange rate is a rate at which
one currency will be exchanged for
another currency and affects trade and
the movement of money between
countries.
•Exchange rates are impacted by both
the domestic currency value and the
foreign currency value.

3. Exchange Rates
• Exchange rates are important to both travelers and
international investors. It's pretty easy to find exchange
rate quotes these days, but you still need to know how
to read them and make calculations based on them.
• We will take a closer look at currency exchange rates.
• Suppose that the EUR/USD exchange rate is 1.20 and
you'd like to convert $100 U.S. dollars into euros.
Simply divide the $100 by 1.20. The result is the
number of euros: 83.33. Converting euros to U.S.
dollars means reversing that process: multiply the
number of euros by 1.20 to get the number of U.S.
dollars.

4. Types of exchange rates
• Exchange rate also known as foreign rate.
Some of the major types of exchange rates
are as follows
 Fixed exchange rate system
•Flexible exchange rate system
• Manage floating rate system

5. Types of exchange rates
• Fixed Exchange Rate System:
• Fixed exchange rate system refers to a system in which
exchange rate for a currency is fixed by the government.
1. The basic purpose of adopting this system is to ensure
stability in foreign trade and capital movements.
2. To achieve stability, government undertakes to buy
foreign currency when the exchange rate becomes
weaker and sell foreign currency when the rate of
exchange gets stronger.
3. For this, government has to maintain large reserves of
foreign currencies to maintain the exchange rate at the
level fixed by it.

6. Types of exchange rates
• Flexible Exchange Rate System:
• Flexible exchange rate system refers to a system in which
exchange rate is determined by forces of demand and supply
of different currencies in the foreign exchange market.
1. The value of currency is allowed to fluctuate freely according
to changes in demand and supply of foreign exchange.
2. There is no official (Government) intervention in the foreign
exchange market.
3. Flexible exchange rate is also known as ‘Floating Exchange
Rate’.
4. The exchange rate is determined by the market, i.e. through
interactions of thousands of banks, firms and other
institutions seeking to buy and sell currency for purposes of
making transactions in foreign exchange.

7. Types of exchange rates
• Managed Floating Rate System:
It refers to a system in which foreign exchange rate is
determined by market forces and central bank influences the
exchange rate through intervention in the foreign exchange
market.
1. It is a hybrid of a fixed exchange rate and a flexible exchange
rate system.
2. In this system, central bank intervenes in the foreign
exchange market to restrict the fluctuations in the exchange
rate within certain limits. The aim is to keep exchange rate
close to desired target values.
3. For this, central bank maintains reserves of foreign exchange
to ensure that the exchange rate stays within the targeted
value.

8. Nominal and Real exchange rates
Exchange rates are determined by following two
measures
•Nominal exchange rates
•Real exchange rates

9. Nominal exchange rates
• It is the price of one currency in terms of
another currency.
• It is the amount of domestic currency
required to buy one unit of foreign currency.
• Example
A rupee-dollar rate of 228 means that it
costs 228 rupees to buy one dollar.
$1= Rs. 228

10. Nominal exchange rates
•Appreciation
It is the increase in the value of one currency in
relation to another currency. E.g. If Pakistani
currency reduces to 200 rupees per dollar.
•Depreciation
If a currency loses its value against the relative
currency, it is called depreciation. E.g. if Pakistani
currency increases to 250 rupees per dollar.

11. Real exchange rate
• It is the relative prices of the goods of two countries.
• It tells us the rate at which we can trade the goods of
our country for the goods of another.
• Example
Suppose an ice-cream in America costs $2 and a similar ice-
cream in Pakistan costs 228 rupees. To compare the prices of
both ice creams we must convert them into a common currency.
If a dollar is worth 228 rupees, then the American ice cream
costs 456 rupees. We conclude that Pakistani ice cream costs
one half of what the American ice cream costs. It means we can
exchange 2 Pakistani ice creams for 1 American ice cream. At
these prices and exchange rate, we obtain one-half of an
American ice cream per Pakistani ice cream.

12. Real exchange rate
•Formula
RER=Nominal exchange rate(foreign price) ÷
domestic price
• The real exchange rate depends on the nominal
exchange rate and the prices of goods in the
local currencies.
• Any change in nominal exchange rate or the
prices of goods in local currencies changes the
real exchange rate.

13. Real exchange rate and trade balance
• Trade balance
• It is the difference between the monetary value
of a nation’s exports and imports over a certain
time period.
• When real exchange rate increases, it means our
country’s currency’s value depreciated. As a
result, the exports become cheaper so, their
demand increases and export earnings increase.
• On the other hand, imports become costly and
their demand should be reduced.
• So depreciation should improve trade balance.

14. Trade Balance and J-curve
• Effect of depreciation on the on the trade balance
over a certain period of time is shown by a J-
curve

15. Trade balance and J-curve
• When depreciation occurs, it takes time for the
export earnings to increase and the imports
demand to decrease.
• Because it takes time to change behaviors in
respond to changes in prices.
• As a result, in the J-curve, the the balance of
trade first decreases.
• After some time when the human behavior
changes in respond to the changes in price and
export earnings increase and imports decrease,
the balance of trade increases.

16. Factors that affect exchange rates
• Factors that can affect the exchange rate
1. Inflation
2. Interest
3. Current rate/Balance of payment
4. Government debt
5. Terms of trade
6. Political stability and performance
7. Recession
8. Speculation

17. Factors that affect exchange rates
• Inflation
A country with a lower inflation rate than another will see an
appreciation in the value of its currency .The prices of
goods and services increase at a slower rate where the
inflation is low.
• Interest
Changes in interest rate affect currency value and dollar
exchange rate. Increase in interest rate cause a country
currency to appreciate because higher interest rate provide
higher rates to lenders.

18. Factors that affect exchange rates
• Current Account:
A country current account reflect balance of trade and
earnings on foreign investment. It consist of total number of
transactions including its exports, importing debt.
• Government debt;
Govt debt is a public debt or national debt owned by the
central government .A country with government debt is less
likely to acquire foreign capital, leading to inflation.

19. Factors that affect exchange rates
• Terms of trade:
The ration of an index of a country export prices to an index
of its import price.
• Political Stability:
Political stability is a variable of great importance in a
country evolution since across time it was identified as
causing low level of economic growth but also it was
presented as a consequences of poor economic
development.

20. Factors that affect exchange rates
• Recession:
A recession can be defined as a sustained period of weak
or negative growth in real GDP (output) that is
accompanied by a significant rise in the unemployment
rate.
• Speculation:
If a country's currency value is expected to rise, investors
will demand more of that currency in order to make a profit
in the near future.