What Is an Exchange Rate?
An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the value of another country's currency compared to that of your own. If you are traveling to another country, you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the price at which you can buy that currency. If you are traveling to Egypt, for example, and the exchange rate for U.S. dollars 1:5.5 Egyptian pounds, this means that for every U.S. dollar, you can buy five and a half Egyptian pounds. Theoretically, identical assets should sell at the same price in different countries, because the exchange rate must maintain the inherent value of one currency against the other.
An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the value of another country's currency compared to that of your own. If you are traveling to another country, you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the price at which you can buy that currency. If you are traveling to Egypt, for example, and the exchange rate for U.S. dollars 1:5.5 Egyptian pounds, this means that for every U.S. dollar, you can buy five and a half Egyptian pounds. Theoretically, identical assets should sell at the same price in different countries, because the exchange rate must maintain the inherent value of one currency against the other.
1. Fixed and Floating Exchange Rates
1.1 Fixed Exchange Rates
There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government central bank sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.
1.2 Floating Exchange Rates
Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting", as any differences in supply and demand will automatically be corrected in the market. Take a look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing.
There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government central bank sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.
1.2 Floating Exchange Rates
Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting", as any differences in supply and demand will automatically be corrected in the market. Take a look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing.
1.3 The Market for Foreign Exchange
In the market for foreign exchange (forex), people trade one country's money for another's. If, for example, you decide to travel to Thailand, you will need to buy some bahts, the currency of Thailand, either before you go or once you get there. In your transaction, you will supply dollars to the foreign exchange market and demand baths
The market for foreign exchange can be analyzed in terms of supply and demand. Americans demand foreign money (and supply dollars) when they buy things abroad, such as vacations, goods, services, factories, and financial assets. Foreigners supply foreign currency (and demand dollars) when they buy things here, such as vacations, goods, services, factories, and financial assets. Although when you buy a Japanese camera, you do not deal in the foreign exchange market, someone did in the process of bringing the camera to you. It may have been the American importer, who would have sold dollars to buy yen, and then used the yen to buy the camera. Or it may have been the Japanese exporter, who sold cameras for dollars and then sold the dollars for yen. In either case, dollars were supplied to the foreign exchange market and yen were demanded
The graph below shows a supply and demand graph for foreign exchange. When foreign currency is cheap, foreign products are cheap in dollars and Americans will want a lot of them. To buy these foreign products, Americans must buy a lot of foreign exchange. When the price of foreign exchange is expensive, so too will be foreign products, and Americans will not want many. Hence, they will not need as much foreign exchange. Thus, the demand for foreign exchange will have the negative slope that demand curves are supposed to have. Unfortunately, we cannot show that the supply curve has a positive slope with this reasoning, (there is no law of supply), but a positive slope is not unreasonable.
- Exchange Rates and Relative Prices
- Import and export demands are influenced by relative prices.
2.1 The appreciation of a country's currency refers to an increase in the value of that country's currency.
- An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency.
- Appreciation of a country’s currency:
- Raises the relative price of its exports
- Lowers the relative price of its imports
2.2 The depreciation of a country's currency refers to a decrease in the value of that country's currency.
- A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency.
- Depreciation of a country’s currency:
- Lowers the relative price of its exports
- Raises the relative price of its imports
Example:
¨ €1 used to be worth $1.
¨ Now €1 is worth $1.46.
¨ The euro is now more valuable. It has appreciated.
¨ So, the dollar is less valuable. It has depreciated.
¨ E has increased from 1.00 to 1.46
As E is the value of the euro in dollars,
¨ E↑ means appreciation of the euro (and depreciation of the dollar)
¨ E↓ means depreciation of the euro (and appreciation of the dollar)
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