An exchange rate (XR) is the price of one currency in terms of another.
Assume that the XR is the amount of foreign currency that can be bought for a unit of the domestic currency. A fall in the XR means the domestic currency is cheaper, that is, more of the domestic currency can be bought for a unit of foreign currency (and less foreign currency can be bought for a unit of the domestic currency).
Agents trade currencies on the foreign exchange (FOREX) market. Currency is bought and sold for many reasons including foreign trade, saving abroad, foreign direct investment and speculation.
An economy could use one of three different systems to determine its XR:
1) Floating XR.
A floating XR is where market forces determine the XR, that is, the XR is determined by the intersection of market demand and supply.
An increase in demand for the domestic currency means the demand curve shifts right and the XR appreciates. The domestic currency is worth more so more foreign currency can be bought for a unit of the domestic currency.
An increase in supply of the domestic currency means the supply curve shifts right and the XR depreciates. The domestic currency is worth less so less foreign currency can be bought for a unit of the domestic currency.
Many factors influence an XR including:
A) Relative Interest Rates.
A rise in the UK’s relative interest rate means UK banks give a higher return than foreign banks, this incentivizes foreign agents to save more in the UK, demand for the £ rises so the XR rises.
B) Relative Inflation Rates.
Purchasing power parity (PPP) means the market XR between two countries equals the ratio of the two country’s prices for the same bundle of goods. Market XRs are influenced by the purchasing power of currencies. If the UK’s inflation is higher than Spain’s, UK rise faster than Spain’s, the same bundle of goods in the UK now costs more than in Spain, UK consumers buy more euros to buy the bundle of goods from Spain, supply of the £ rises and demand for the euro rises until PPP is restored.
C) Boom.
A boom in the UK means that UK consumers’ income rises and they buy more domestic and foreign goods and services, so imports rise and supply of the £ rises so the XR falls. A boom in foreign countries means foreign incomes rise, foreign agents buy more UK exports, demand for the £ rises and the XR rises.
D) Multinational Companies and Foreign Direct Investment.
Multinational Companies may want to set up production in the UK if the UK economy is booming, so they must buy the £, demand for the £ rises and the XR rises.
E) Speculation.
A major determinant of short-term XRs is speculation. Agents may trade currencies to make a profit by buying low and selling high. If agents expect a currency to rise they will buy that currency while the price is low and sell it after its value has risen to make a profit. Speculation that the £ will appreciate means speculators buy the £, there is an inflow of ‘hot money’ into the UK and the XR rises.
A floating XR is determined by market forces, but market forces can be unstable. An economy’s XR could become unstable if demand and supply for its currency keeps changing. Instability creates uncertainty, and uncertainty means agents cannot plan so they cannot invest.
2) Fixed XR.
A fixed XR is where the central bank buys and sells the domestic currency to keep the XR at a chosen fixed level.
A central bank can revalue the XR by using its foreign currency reserves to buy up more of the domestic currency so that the value of the domestic currency rises.
A central bank can devalue the XR by using domestic currency to buy foreign currency so that the value of the domestic currency falls.
A fixed XR creates stability, stability makes the future more certain so it is easier to plan and invest. A central bank could devalue its domestic currency to make the domestic currency more internationally price competitive so that the current account moves towards a surplus. However, if country A uses a fixed XR to gain international price competitiveness other countries could do the same in retaliation so that there is no change in global XRs. Moreover, a central bank cannot keep buying domestic currency with its foreign exchange reserves because eventually those reserves will deplete.
3) Managed XR.
A managed XR is where the central bank set a target for the XR and allows the XR to float around that target, the central bank will buy/sell the domestic currency to make sure the XR stays close enough to its target.
A managed XR means the domestic currency’s value maintains a degree of stability because the central bank will not let it rise too far above or fall too far below the band it sets. The XR can fluctuate but the target provides some stability, making it easier to plan and invest in the domestic economy.
Effects of An XR Change A fall in the XR causes:
1) Current Account Surplus.
If the £ is weaker, UK exports are cheaper so exports rise, imports are dearer so imports fall and the current account moves towards a surplus.
2) Economic Growth.
If the £ is weaker, UK exports are cheaper so exports rise, imports are dearer so imports fall, the current account moves towards a surplus, AD rises and shifts right so real GDP increases.
3) Inflation.
If the £ is weaker, UK exports are cheaper so exports rise, imports are dearer so imports fall, the current account moves towards a surplus, AD rises and shifts right so there is demand-pull inflation. Also, because imports are dearer, UK firms’ imported raw materials are dearer, UK firms’ costs rise and there is cost-push inflation.
4) More Employment.
If the £ is weaker, UK exports are cheaper, demand for UK exports rise, UK firms must produce more to export so they must hire more workers and unemployment falls. Additionally, imports are dearer so UK consumers switch to buying more UK goods because they are relatively cheaper, UK firms must produce more so they must hire more workers and unemployment falls.