The document discusses exchange rates, defining them as the price of one currency in terms of another, and explains how they are influenced by demand and supply factors in the foreign exchange market. It outlines types of exchange rate systems, including fixed, floating, and managed exchange rates, detailing central bank interventions and factors affecting currency values. Additionally, the document touches on concepts like appreciation and depreciation of currencies, as well as the role of speculation and interest rates in determining exchange rates.

1. 1
Exchange Rates

2. 2
EExxcchhaannggee RRaattee:: DDeeffiinniittiioonn
 The exchange rate is the price of a currency in terms of
another currency. Thud the exchange rate for the US
dollar can be expressed in the amount of British pounds,
EURO or Mexican pesos needed to but one dollar.
 If $US1 = €0.82, then the exchange rate for EURO =
(1/0.82) = $US 1.22
 Q: The exchange rate for the US dollar is 7.5 Swedish
Crowns (SEK), What is the exchange rate for the SEK?
A: 1 SEK = $ US 0.133

3. Currencies are bought and sold on a foreign exchange market.
The demand for a currency is a function of three main variables:
1.The demand for other countries’ goods and services
2.The demand for foreign direct investment and portfolio
investment in another country
3.Speculative demand
People and import/ export firms will buy currencies from banks
and foreign exchange offices to conduct international
transactions. Foreign exchange brokers will in turn be used by
banks to supply needed currencies and to cash-in unneeded
currencies. Finally the central banks of trading countries may
intervene on the currency market by adding to the foreign
reserves in order to adjust the exchange rate.
3

4.  The SSuuppppllyy ccuurrvvee ffoorr ccuurrrreenncciieess iiss uuppwwaarrdd
ssllooppiinngg bbeeccaauussee aa hhiigghheerr pprriiccee ooff ccuurrrreennccyy XX
wwoouulldd--cceetteerriiss ppaarriibbuuss-- wwoouulldd eennaabbllee cciittiizzeennss ooff
tthhaatt ccoouunnttrryy (XX)) (ttoo bbuuyy mmoorree ggooooddss ooff ccoouunnttrryy YY..
IInn ddooiinngg mmoorree ccuurrrreennccyy XX wwiillll bbee aavvaaiillaabbllee iinn
ccoouunnttrryy YY’’ss mmaarrkkeett..
4

5. 5
EXPLANATION
When the value of the rupee increases in
terms of dollars; rupee appreciates, you will
be able to buy more from the same amount of
rupees spent, therefore the supply of rupees
will increase.

6. 6
DEMAND CURVE
 TThhee ddeemmaanndd ccuurrvvee iiss ddoowwnnwwaarrdd ssllooppiinngg ttoo
iinnddiiccaattee tthhaatt cciittiizzeennss ooff ccoouunnttrryy XX wwiillll bbuuyy mmoorree
ccuurrrreennccyy YY wwhheenn tthheeyy ggeett mmoorree ooff iitt –– aanndd mmoorree
ggooooddss-- ffoorr tthheeiirr ccuurrrreennccyy XX..

7. 7
EXPLANATION
When the rupee value falls in terms of other
currencies ,say dollar, we would need more
rupees to buy same amount of goods,
demand for rupees would increase.

8. 8
The exchange raTes for The
euro and The us dollar
P of € in $US
Initial equilibrium:
$US 1 = € 0.82
And thus… €1 = $US 1.22
P of $US in €
Q €(millions/day) Q $(millions/day)
EURO
S$0
S$1
0.82
0.81
Q Q$0 Q$1 €0 Q€1
D$
D€0
D€1
S€
1.23
1.22
US DOLLAR
NNoottee:: DDoo nnoott ccoonnffuussee DDDD SSSS ffoorr mmoonneeyy wwiitthh ffoorreeiiggnn eexxcchhaannggee mmaarrkkeettss

9. 9
FFiixxeedd eexxcchhaannggee rraatteess
 We know that exchange rates are established by market forces of demand and
supply. When a group of countries instead keep their exchange rate constant thus
establishing a fixed exchange rate.
 Such countries use the central government to intervene on the foreign exchange
market in order to keep exchange rate within a narrow band-much like the
mechanism used in a buffer stock mechanism.
 The central government can affect the exchange rate in the short run by buying or
selling its own currency on the foreign exchange market, and by adjusting the
interest rate to influence investors’ demand for the currency.
 In the long run, governments might intervene using fiscal policies, supply-side
measures and protectionism to adjust national income in order to increase or
decrease exports and citizens’ propensity to import.
TTyyppeess ooff FFiixxeedd eexxcchhaannggee rraatteess
 The Gold Standard
 The Bretton Woods exchange rate system

10. HHooww aa FFiixxeedd eexxccHHaannggee RRaattee wwooRRkkss
10
Outside the band
Ceiling
LR equilibrium
Floor
D£2
Q1 Q2 Q3Q4
P of £ in US$
2.84
2.82
2.80
2.78
S£1
Q £(millions/day)
DD £1 £0
B
A
C
D
S£0
keeping tHe pound down
When exchange rate rises above
2.82 the Bank of England will have
to sell Q1Q3 (S£0 shifts to S£1)
on the foreign exchange market to
keep the pound within the band
* (For ‘keeping the pound up’) refer pg 565 of textbook)

11. 11
otHeR tools aFFecting excHange
Rates
 Central banks are not limited to buying and selling their currencies in
order to influence the exchange rate. There are two alternatives in the
short term:
1) The central bank can change the interest rate. If it wishes to increase
the exchange rate, the interest rate could be raised. This would
influence the demand for the home currency as foreign investors/
speculators would see a higher rate of return in holding the currency –
demand for the home currency would rise.
2) The central bank could borrow from the International Monetary Fund.
The IMF was created to aid countries having difficulty keeping a
stable exchange rate. When a country’s currency falls, and the central
bank runs out of foreign exchange to buy up the home currency, the
central bank can borrow funds from the IMF to get over the crisis.

12. 12
FFllooaattiinngg eexxccHHaannggee RRaatteess
 When a currency’s value is totally determined by market forces – e.g. supply
and demand for the home currency – there is a floating exchange rate.
 A currency ‘floats’ amongst the other currencies on the market and the price is
set in accordance with the mechanisms of supply and demand outlined earlier.
 The demand for a currency is derived from demand of goods, services and
investments in other countries. There is also speculation in currency – which is
perhaps the main short run determinant of exchange rates – which is based on
the predictions/ emotions of currency speculators ‘betting’ on changes in
exchange rates
 In a floating exchange rate system, perfect information is an important issue.
 Central banks have a tendency to intervene to correct what is considered to be
disequilibrium in a floating exchange rate. This is called managed float or dirty
float. Dirty float implies that impure market forces (central bank interventions)
are present.

13. 13
MMaannaaggeedd eexxccHHaannggee
RRaatteess
 When currencies are allowed to fluctuate within a narrow band in the
short run, and allowed to be realigned in the long run, there is a
managed exchange rate. The most common version is when a
government pegs its currency to another.
 Completely fixed rates cause a problem of inflexibility, since
economies have different fundamentals such as growth rates and
inflation rates.
 In the long run it could be very costly for a country with a weakening
currency to defend its links with other countries.
 That is why we have managed exchanged rates

14. 14
AAnn eexxaammppllee
WWhheenn tthhee eexxcchhaannggee rraattee eexxcceeeeddss tthhee cceeiilliinngg ooff
$$UUSS 00..1122008822 ppeerr YYuuaann,, ppooiinnttss AA iinn tthhee
ddiiaaggrraamm,, tthhee CChhiinneessee cceennttrraall bbaannkk sseellllss YYuuaann
((bbyy bbuuyyiinngg ffoorreeiiggnn ccuurrrreenncciieess)) iinn oorrddeerr ttoo
iinnccrreeaassee tthhee ssuuppppllyy aanndd lloowweerr tthhee eexxcchhaannggee
rraattee..
WWhheenn tthhee rraattee ffaallllss bbeellooww tthhee fflloooorr lleevveell ooff
$$UUSS 00..1122002244 ppeerr YYuuaann,, ppooiinnttss BB,, tthhee cceennttrraall
bbaannkk bbuuyyss YYuuaann ((wwiitthh ffoorreeiiggnn ccuurrrreenncciieess))
wwhhiicchh iinnccrreeaasseess ddeemmaanndd ffoorr YYuuaann aanndd

15. • If there is fundamental
upward movement in the Yuan
i.e. the managed rate is below
the long run rate the market
sets, the Chinese central bank
can realign the currency by
revaluating the Yuan: time t1.
•Conversely, a fundamental
overvaluation of the Yuan,
shown at time t2, might cause
massive purchasing of the Yuan
and running down the foreign
reserves.
15
aa MMaannaaggeedd eexxccHHaannggee
RRaattee
Revaluation
Devaluation
Ceiling
Ceiling
Ceiling A
A
A
B
B
B Floor
Floor
Floor
0.12082
0.12048
0.12024
1995 2004
t1 t2
P of Yuan in $US
time

16. 16
aappppRReecciiaattiioonn aanndd
ddeeppRReecciiaattiioonn
 WWhheenn tthhee eexxcchhaannggee rraattee ooff aa ffrreeeellyy ffllooaattiinngg ccuurrrreennccyy rriisseess,, tthhee
ccuurrrreennccyy hhaass aapppprreecciiaatteedd..
 AA ffaallll iinn tthhee vvaalluuee ooff aa ffllooaattiinngg ccuurrrreennccyy mmeeaannss tthhee ccuurrrreennccyy hhaass
ddeepprreecciiaatteedd..
RReevvaalluuaattiioonn aanndd ddeevvaalluuaattiioonn
 WWhheenn tthhee ggoovveerrnnmmeenntt rree--ppeeggss aa ffiixxeedd// ppeeggggeedd ccuurrrreennccyy,, tthhee ccuurrrreennccyy hhaass
bbeeeenn rreevvaalluueedd..
 WWhheenn aa ffiixxeedd oorr ppeeggggeedd ccuurrrreennccyy iiss rreeaalliiggnneedd ttoo aa lloowweerr vvaalluuee,, tthhee ccuurrrreennccyy
hhaass ddeevvaalluueedd..

17. 17
EEffffEEccttss oonn EExxcchhaannggEE
rraattEEss
Main determinants of the exchange rate
TTwwoo mmaaiinn aassssuummppttiioonnss::
 TThhee ccuurrrreennccyy iinn qquueessttiioonn ((tthhee UUSS ddoollllaarr)) iiss nnoott
oonnllyy ffllooaattiinngg bbuutt aallssoo ffrreeeellyy ffllooaattiinngg--tthheerree iiss
nnoo iinntteerrvveennttiioonn bbyy tthhee UUSS cceennttrraall bbaannkk
 EEaacchh ooff tthhee ddeetteerrmmiinnaannttss mmeennttiioonneedd llaatteerr aarree
ooppeerraattiinngg uunnddeerr tthhee cceetteerriiss ppaarriibbuuss ccoonnddiittiioonnss--
aa cchhaannggee iinn iinntteerreesstt rraatteess iiss nnoott aaccccoommppaanniieedd
bbyy aa cchhaannggee iinn aannootthheerr vvaarriiaabbllee

18. ttrraaddEE ffllooww When American exports increase, there will be an increased demand
for the dollar as importers in other countries will need more dollars to
buy the American goods. Increased exports will increase the demand
for the dollar, causing the shift in the demand curve on slide 18 from
D$0 to D$1 and subsequently an appreciation of the dollar from x 0
to x 1. (x = ex; delta = change).
An increase in imports or an increase in American tourism abroad
would imply increased trade of dollars for goods/ services causing an
increase in supply of dollars on the market – S$’0 to S$’2 – and the
dollar depreciates from x’ 0 to x’ 2 (slide 18)
=> US exports ↑demand for $US ↑x for $US↑ (and vice versa)
=> US imports ↑supply of $US ↑ x for $US↓ (and vice versa)
18

19. 19
capital flows/ iinnttEErrEEsstt rraattEE
cchhaannggEEss
**
 Inflows of investment to the US  demand for
the $ US ↑ x for the $US↑ (and vice versa)
 US investment abroad↑  supply of $US↑  x
for $US↓ (and vice versa)

20. 20
VariablEs affEcting thE ExchangE rraattEE ffoorr tthhEE UUss ddoollllaarr
D$2
D$1
D$0
S’$1
S’$0
S’$2
S$
D’$
US dollar US dollar
Q2 Q0 Q1 Q’1 Q’0 Q’2
P of $US (TWI)
P of $US (TWI)
Q$ (millions/day) Q$ (millions/day)
x 1
x 0
x 2
x ’1
x ’0
x ’2

21. 21
IInnccrreeaassee iinn ddeemmaanndd ffoorr tthhee UUSS
ddoollllaarr::
IInnccrreeaassee iinn ssuuppppllyy ooff tthhee UUSS
ddoollllaarr::
↑ US exports of goods/ services
↑ in foreign investment in US
↑ in US interest rates
↓ in US inflation rate
Speculative buying of US dollar
US central bank buys dollars (= decrease
in foreign reserves)
↑ US imports of goods/ services
↑ in US foreign investment abroad
↑ in foreign interest rates
↓ in foreign inflation rates
Speculative selling of US dollar
US central bank sells dollars (= increase
in foreign reserves)
DDeeccrreeaassee iinn ddeemmaanndd ffoorr tthhee UUSS
ddoollllaarr::
DDeeccrreeaassee iinn ssuuppppllyy ooff tthhee UUSS
ddoollllaarr::
↓ US exports of goods/ services
↓ in foreign investment in US
↓ in US interest rates
↑ in US inflation rate
↓ US imports of goods/ services
↓ in US foreign investment abroad
↓ in foreign interest rates
↑ in foreign inflation rate

22. 22
iinnffllaattiioonn
 Ceteris Paribus:
 Relative inflation in US↑ demand for US exports &
US demand for imports ↓  demand for US dollar ↓ &
supply of US dollar↑  x for the $US ↓
 Relative inflation in US↓ demand for US exports↑ &
US demand for imports ↓ demand for US dollar ↑ &
supply of US dollar↓  x for $US ↑

23. 23
ssppEEccUUllaattiioonn
 Speculative belief that the US dollar will
depreciate  US dollar is sold  supply of the
US dollar↑  x for $US↓
 Speculative belief that the US dollar will
appreciate  US dollar is bought  demand for
the US dollar ↑  x for the $US↑

24. 24
UsE of ffoorrEEiiggnn EExxcchhaannggEE
rrEEssEErrVVEEss
 Governments can intervene on the foreign currency market via the
foreign currency reserves held in the central bank
 US dollar depreciates ‘too much’  US central bank intervenes by
buying the US dollar  demand for dollar ↑  x for the $US ↑
(decrease in US foreign reserves & inflow to US capital account)
 US dollar appreciates ‘too much’  US central bank intervenes by
selling the US dollar  supply of the US dollar ↑  x for $US ↓
(decrease in the US foreign reserves & inflow to the US capital
account)

25. 25
FFiixxeedd eexxcchhaannggee rraatteess
Advantages:
 Predictability and certainty
 Exchange rate stability encourages trade
 Fiscal/ monetary discipline domestically
 Less risk of speculation
Disadvantages:
 Loss of domestic monetary policy freedom
 Need of large foreign reserves
 Possibility of increased unemployment
 Possibility of imported inflation

26. 26
FFllooaattiinngg eexxcchhaannggee rraatteess
Advantages:
 The balance of payments automatically adjusts
 No large foreign reserves necessary
 Freedom in domestic/ monetary policies
 Reduced Speculation
 Less risk of imported inflation
Disadvantages:
 Instability and lack of predictability
 Lack of monetary/ fiscal prudence
 Loss of competitiveness and efficiency

27. Monetary IntegratIon (single
cIunforrrmeatniocn:ies)
In 1999 the EURO technically came into being and during 2001 (from all 15 members
except UK, Denmark, Sweden and Greece) were ‘locked’ in place in exchange terms.
A European central bank took over the task of setting and implementing monetary
policies for all EMU countries. This project created one of the largest shifts in
economic power in history.
In order for each country wishing to join to be eligible, they had to adjust domestic
fiscal and monetary policies to fulfill the following criteria:
Inflation could be no more than 1.5 percentage points above the average inflation of
the three countries with the lowest inflation
Interest rates had to be within 2 percentage points of the average of the three
countries with the lowest interest rates
A maximum budget deficit of 3% of GDP
Exchange rates had to be kept within a narrow band for 2-3 years
The national debt had to be lower than 60% of GDP
27

28. 28
eeMMUU:: CCooSSttSS aannDD BBeenneeFFIIttSS
Benefits:
 Trade creation
 Increased efficiency due to increased competition
 Benefits of scale
 Lower transaction costs
Costs:
 Loss of domestic monetary policy
 Restrictions on domestic fiscal policy
 Regional unemployment

29. 29
PPuurrcchhaassiinngg PPoowweerr PPaarriittyy**
TThhee tthheeoorryy ooff ppuurrcchhaassiinngg ppoowweerr ppaarriittyy ssttaatteess tthhaatt
eexxcchhaannggee rraatteess wwiillll iinn tthhee lloonngg rruunn aaddjjuusstt ttoo ddiiffffeerreenntt
iinnffllaattiioonn rraatteess iinn ccoouunnttrriieess,, lleeaaddiinngg ttoo eeqquuiilliibbrriiuumm
wwhheerree aa ggiivveenn aammoouunntt ooff hhoommee ccuurrrreennccyy ttrraaddeedd ffoorr aa
ffoorreeiiggnn ccuurrrreennccyy wwiillll bbuuyy aann eeqquuaallllyy--ssiizzeedd bbuunnddllee ooff
ggooooddss..
*Refer to textbook for limitation of this theory

30. 30
aarrBBIIttrraaggee aannDD tthhee llaaww ooFF oonnee
pprrIICCee
 Assume two countries, X and Y, side-by-side which have no trade barriers;
mo transaction costs; no transport costs; homogenous goods; identical
expenditure taxes; and a floating exchange rate.
 Country X can buy a kilo of flour for 2 ($X) domestically.
 Country Y can buy a kilo of flour for 3 ($Y) domestically
 The exchange rate is $X1 = $Y2; or $Y2 = $X0.5
 The following two things will happen:
(i) Citizens from X will cross over to Y to buy flour, seeing as how $X2 they pay
at home would get them $Y4 and then 1.33 kilos of flour;
(ii) There would be arbitrage, as enterprising people in Y would buy flour
domestically and sell it in X for just under $X2 per kilo.
The result:
 Increased demand for the Y dollar will cause the $Y to appreciate.
 Also, the traders from Y will exchange their X dollars for Y dollars, thereby
increasing supply of $X and causing a depreciation of the $X.

31. Demand for Y flour will cease and arbitrage activities will
end when the exchange rate between the two countries is
such that the price is the same for both countries.
i.e. 1 kilo flour in X = $X2 = $Y3= 1 kilo flour in Y
31
llaaww ooFF oonnee pprrIICCee::
AAssssuummiinngg tthhaatt tthheerree aarree nnoo iimmppeerrffeeccttiioonnss,, ttwwoo
hhoommooggeennoouuss ggooooddss mmuusstt uullttiimmaatteellyy hhaavvee tthhee ssaammee
pprriiccee oonn aa mmaarrkkeett

32. 32
tthhee llaaww ooFF oonnee pprrIICCee aannDD tthhee pppppp
tthheeoorryy
 Consider our previous situation. What if the inflation rates in X & Y
would differ, exchange rate remaining constant.
Say for e.g. 10% inflation in Y and 0 in X.
 The answer: 1 kilo of flour would cost $Y3.3 in Y but still $X2 in X. If
the exchange rate remained unchanged, Y citizens would get more flour
for their money in X and arbitrage would be conducted in the other
direction – Y would import flour now. This would continue until a new
exchange rate came in that gave both X & Y equal PPP.
 2$X = 3.3$Y  1$X = 1.65$Y, or 1$Y = 0.60$X.
 The X dollar has appreciated by 10% and the Y dollar has depreciated
by 10%.
 This is essentially the PPP theory.