Foreign exchange rates
Written by Amina Meirkhan | Proofread by Yasmin Uzykanova
Definitions:
Foreign exchange rate - value or price of a currency expressed in terms of another currency.
Equilibrium market foreign exchange rate - price at which the demand and supply of a currency are equal.
Current account deficit - when the value of imports exceeds the value of exports.
Current account surplus - when the value of exports exceeds the value of imports.
Interest rate - price of borrowing money.
Inflation - rate at which prices rise, a general and continuous rise in prices.
Price elasticity of demand (PED) - responsiveness of demand to changes in price.
Balance of trade - difference between visible exports and imports.
The foreign exchange rate of a currency is determined by the market supply and demand of the said currency.
Demand for a currency exists when foreign consumers are willing and able to import goods and services from the country, as they exchange their currency for this.
Supply of a currency exists when the country’s local consumers are willing and able to import goods and services from other countries, as they exchange the currency for another one.
Example of equilibrium market foreign exchange rate:
Causes of foreign exchange rate fluctuations:
Changes in demand for exports and imports - when a current account deficit occurs, more of the country’s currency is supplied than it is demanded. This causes the exchange rate to fall. If there is a current account surplus, the exchange rate will rise.
Inflation - if a country’s inflation is higher than others’, their prices on the international market will be higher than other countries’, which will lead to a fall in demand for exports and fall in demand for the currency. This leads to a decreased exchange rate.
Changes in interest rates - if a country’s interest rates are high, foreign firms and residents might want to invest and save money there, which will lead to a higher demand for the currency and a higher exchange rate. Vice versa when the interest rates fall.
Multinational corporations - investment in overseas productions requires use of foreign currency. Having a foreign company in a country increases the country’s exchange rate because demand for its currency rises. Vice versa happens when a country owns a company overseas.
Speculation - companies move money around the world to earn profit through higher interest rates and changing exchange rates. If speculators aren’t confident in the economy of the country, they withdraw their money, which devalues the currency. Vice versa happens with high confidence in the economy.
Government intervention - government intervention can affect exchange rates, for example, the government can sell their reserves of their currency in order to supply more of it and decrease demand if needed.
Consequences of foreign exchange rate fluctuations:
A fall in foreign exchange rate causes import prices to rise and export prices to fall, and vice versa for a rise in foreign exchange rate.
Therefore, when foreign exchange rate falls, exports become cheaper than imports, so demand for them increases and this leads to current account surplus. Vice versa if foreign exchange rate rises.
When PED is elastic (>1), a fall in foreign exchange rate improves the balance of trade.
When PED is inelastic (<1), a rise in foreign exchange rate will worsen the balance of trade.
