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Exchange Rate

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Economics

When you travel to a different country, you need to exchange one currency for another, so you can buy things. Have you had this experience? Have you ever wondered how this exchange rate is decided and why currency exchange rates are constantly changing? Read on and find out!

The exchange rate is the rate at which one foreign currency is exchanged for another.

If £1 is worth €1.17, for every £1 you will receive €1.17.

Keep in mind that the values of the freely floating exchange rates are fluctuating frequently due to external factors such as inflation, supply and demand of credit, government initiatives, and monetary policy.

The freely floating exchange rate is the currency exchange rate determined by the supply and demand of a currency. As a result, exchange rates that follow this system are likely to fluctuate based on currency exchanges in the Forex market.

It's important to know that currencies are frequently bought and sold on the foreign exchange market. This market is referred to as the Forex and is used by investors, banks, and individuals to exchange foreign currencies for different purposes.

What are the currency exchange rates?

Currency exchange rates indicate the value of one currency in relation to another. In addition to external economic factors such as inflation or supply and demand of credit, currency exchange rates are also influenced by the type of exchange rate system that the currency is adjusted by.

Exchange rates in the freely floating system

Exchange rates that are determined by the freely floating system are not stable; they constantly fluctuate up and down.

This is because exchange rates are mainly set by the Forex market based on the supply and demand of currency. The freely floating exchange rate example is the US dollar as the dollar’s currency value changes according to the dollar’s supply and demand in the Forex market.

Exchange rate Freely floating exchange rate StudySmarterFigure 1. Freely floating exchange rate, StudySmarter.º

Figure 1 represents the exchange rates in the freely floating system. If there is an increase in supply and the S1 curve shifts to S2, but if the demand remains at D1, this will result in currency depreciation (E1 to E2). On the other hand, if the demand increases, the demand curve will shift from D1 to D2 and if the S1 stays stable this will cause the currency to appreciate (E1 to E3).

In figure 1 we can see different scenarios of currency exchange rates depending on their quantity supplied and demanded (look for scenarios labelled Q1, Q2, Q3 and Q4), this can result in the exchange rate of E1, E2 or E3. E3 is the highest currency exchange rate and E2 is the lowest.

Therefore, if E1 moves to E3 that means the currency is appreciating. In other words, it increases in value. Alternatively, if the currency drops from E1 to E2 this means that the currency is depreciating or in other words decreasing in value.

Exchange rates in the fixed system

The exchange rate in the fixed system is the policy established by a government or central bank regarding the currency exchange rate. In this system, central banks or the government create the value of the currency at its fixed rate when exchanging it for another currency.

The Bank of England can announce the British pound exchange rate to the US dollar at the rate of US $1.50. This fixed exchange rate is known as ‘central peg’, ‘central rate’, ‘parity’, or ‘par value’. The majority of countries in the Caribbean islands including Barbados and Bermuda and in Asia, including Hong Kong and Macau, have fixed or so-called pegged exchange rates with the US dollar.

An exchange rate may also be semi-fixed, which means it can be affected by market forces such as the supply and demand of currency within the boundaries determined by the government.

The semi-fixed exchange rate refers to the exchange rate between two currencies that is allowed to fluctuate within a set range. The range lies between the ‘price ceilings’ and ‘price floors’. Central banks usually determine semi-fixed exchange rates.

Therefore, the central banks set fixed exchange rates limits known as ‘ceilings’ and ‘floors’, these are set just above or below the ‘central peg’.

Price ceilings are usually set by central banks and they refer to the highest fixed rate at which currency can be exchanged for another in the semi-fixed system.

Price floors are usually set by central banks and they refer to the lowest fixed rate at which one currency can be exchanged for another in the semi-fixed system.

Moreover, central banks' interventions are necessary in order to keep the exchange rate at the fixed-rate, or, in the semi-fixed system, not to exceed ceilings and floors. Figure 2 below represents the example of a fixed exchange rate or pegged exchange rate where the rate is fixed at UK £1 exchanged for U.S. $1.50.

However, in the semi-fixed system, banks allow some flexibility due to the influence of market forces. This results in the exchange rate fluctuating between price ceilings and floors. In Figure 2 below, the UK £1 can be exchanged for $1.52 or $1.48 because these are the highest and lowest rates that the dollar can be exchanged for a pound representing the price ceiling and floor respectively.

Exchange rate Fixed exchange rate StudySmarter

Figure 2. Fixed and semi-fixed exchange rate - StudySmarter

Exchange rates in the managed system

The majority of national governments follow this exchange rate system which is in the middle between floating and fixed exchange rates.

Exchange rates in the managed system are influenced by the markets and government interventions of buying and selling currencies or making some adjustments to monetary policies.

Figure 3 shows how managed exchange rates can be divided into two categories: ‘dirty floating exchange rates’, which lean toward the floating exchange rate system but remain managed, and ‘adjustable peg exchange rates’, which lean toward the fixed exchange rate system but remain managed.

Exchange Rate Different types of exchange rate systems StudySmarterFigure 3. Different types of exchange rate systems - StudySmarter.

Historical exchange rates

We could say that the fixed exchange rate is a historical exchange rate as it was one of the first exchange rate systems. It was introduced as the ‘gold standard’, which was first adopted by England in 1717.

The ‘gold standard’ system was created to establish currencies’ fixed exchange rates to gold. The exchange rate reflected the value of the currency: the more valuable the currency, the fewer units someone needed of it to purchase gold.

Although the gold standard system disappeared in 1971,1 the fixed system of foreign currency exchanges follows the same principle.

Government interventions to influence the exchange rate

Usually, the government intervenes to influence exchange rates in situations when either currency exchange rates are quickly decreasing in value or gaining too much value. The aim of the government interventions is to make the currency exchange rate in favour of the nation.

First, we must acknowledge that depending on which systems the exchange rates are regulated by determines the level of government interventions in regards to exchange rates.

Government intervention in different exchange rate systems

Compared with other systems, the floating system is the one in which the government will have less power to intervene. The floating system determines exchange rates influenced by the supply and demand of a currency in the market.

In the managed system, along with the supply and demand of a currency in the market, the government will be able to intervene by managing the currency exchange rate. This is to prevent the currency from losing or gaining too much value.

In the fixed system the government will have the most involvement compared to other systems as it will be constantly intervening in order to maintain the fixed currency exchange rate system.

Methods governments use to influence exchange rates

  • Buying or selling foreign exchange reserves to keep the currency stable and avoid devaluation or overvaluation. As well as influence the direction of the desired exchange rate.

  • Borrowing. The government can borrow foreign currency to be able to buy domestic currency in order to increase its value.

  • Increasing interest rates. Higher interest rates influence the currency to appreciate. This is because higher interest rates mean that it will be more favourable for people to save and this will also attract foreign investment. But governments need to be careful with raising interest rates as this may lower the demand in the economy and slow down economic growth.

  • Reducing inflation. By using monetary or fiscal policies, the government can influence the aggregate demand to decrease. As a result, inflation should go down and domestic goods should become more internationally price competitive, which would raise the value of the domestic currency through higher export demand.

  • Implementing supply-side policies. Supply-side policies (including increasing education, job training, and others) aim to increase the productive capacity of the economy in the long run. However, the process may take a long time to work. Once it is successful, it will make the economy more competitive and therefore cause the currency to appreciate.

The euro exchange rate

The euro was introduced in the European Union (EU) on 1 January 2001. Its main objective was to lower the trading costs between countries. Before the euro was introduced in the EU, trading between countries with their own currencies was more expensive due to their different exchange rates. Another objective was to give a competitive advantage to those countries whose exchange rates were falling.

The agreement among many European countries to use the euro as a common currency is also known as a currency union or monetary union. It means that the group of countries have the agreement of sharing the same currency as well as adopting common monetary and foreign exchange policies.

However, the introduction of the euro as a common currency has not worked as expected. Although the eurozone is a currency union it was not an optimal currency area.

For the common currency to be optimal, currency coordination in fiscal and monetary policy is required. But in the eurozone, there is no authority that can facilitate fiscal policy and fiscal transfers. Moreover, countries with huge microeconomic differences joined the eurozone.

This lack of fiscal policy coordination and their economic differences has left poorer countries in the eurozone, including Greece and Portugal, in huge government debt. During the 2007 crisis, Greece, Portugal, and other poorer countries kept borrowing from richer countries like Germany and the Netherlands. This left them with significant amounts of debt that they were unable to repay. This, in turn, caused a eurozone crisis and left the countries in crisis and with high unemployment rates.

As you can see, joining a currency union isn’t always good for a country. Let’s look at the advantages and disadvantages of joining a currency union.

Advantages of joining a currency union

Transfer of wealth. Due to a common fiscal policy, wealth is transferred from the richer parts of the union to the poorer parts. Thus, the poorer parts of the union will see economic improvements. The wealth is usually transferred by taxation and public spending.

Improving competitiveness in the poorer regions. The implementation of fiscal transfers in the common union allows richer countries to transfer funds to poorer countries to restore their competitiveness and reduce inequality. For example, this can be done by giving funds to improve infrastructure.

Disadvantages of joining a currency union

Inability to restore competitiveness. Due to the common currency, the country can’t restore its competitiveness by devaluing its own currency.

Fall in real wages. Since the currency can’t be devalued to regain competitiveness, the only way the country can regain competitiveness is by dropping the real wages.

Economic crisis. As there is no one to coordinate borrowing between the rich and the poor countries, this can lead to excessive borrowing by poorer countries in the currency union. This can lead to a huge amount of government debt in poorer countries that can cause an economic crisis.

Not all countries in the EU have adopted the euro (€) currency. In fact, 19 out of 27 EU members currently have the euro as a common currency.

How to calculate the foreign exchange rate

The first step to calculating a foreign exchange rate is to know the current exchange rate between two currencies. For example, currently, £1 can be exchanged for US $1.33.

Once we know the exchange rate, we need to calculate the exchange rate for a set amount. In a business situation, the set amount would be usually the invoiced amount from the foreign suppliers or total sales in foreign currency. Let's take a look at an example below:

A UK company buys home decorations from China and sells them in the UK.

The supplier is paid in USD.

This month’s invoice of a Chinese supplier is U.S. $30,000.

What is the cost of goods for a UK company in GBP if the exchange rate is £1 = $1.33?

The calculation follows:

This means that the cost of goods for the UK company in pounds is £22,556.

What is the best exchange rate?

In today’s world, both extreme systems (floating and fixed) are controlled in some way by interventions from government or banks systems. Thus, the main question is which exchange rate is the best fit for whom?

Floating exchange rate

The floating exchange rate can be best used to reflect the true currency value as it is based on the supply and demand of a currency in the free market. Additionally, by adopting a floating exchange rate system, instead of using time and resources to manage the exchange rate, the government can focus on domestic objectives, such as controlling inflation and reducing unemployment.

Even though this is a freely floating rate, governments and central banks sometimes get involved to keep the currency stable and prevent it from dropping or increasing too much. Nevertheless, since the currency is heavily influenced by trades of individuals and businesses, it may not reflect the real value of a country’s goods and services.

Fixed exchange rate

The fixed exchange rate may be the best exchange rate for businesses as they can be certain about the prices of imports and exports. Further, a fixed exchange rate system can help to encourage investment since firms will have more certainty about exchange rates.

Nevertheless, since the exchange rate is fixed regardless of the supply and demand of a currency in the Forex market, the fixed system can cause overvaluation and devaluation of the currency, resulting in economic uncertainty and a misallocation of resources. A fixed exchange rate can also cause extreme deflation if there is a shortage of currency in the fixed system.

Overall, there is no best exchange rate system. The system must be chosen according to the country’s goals and priorities and reflections of benefits as well as drawbacks.

Exchange Rate - Key takeaways

  • The exchange rate is the rate at which one foreign currency is exchanged for another.
  • The key types of exchange rates systems are the freely floating, fixed, and managed.
  • Floating exchange rates are not stable and continue to fluctuate due to the constantly changing supply and demand in the open market.
  • The exchange rate in the fixed system is the policy that is established by a government or central bank regarding the currency exchange rate. In this system, the government makes the value of the currency at its fixed-rate when exchanging it for another currency.
  • Exchange rates in the managed system mostly depend on the market situation and some regulations and interventions by central banks and governments.
  • The key methods that governments use to influence exchange rates are buying or selling foreign exchange reserves, borrowing, increasing interest rates, increasing inflation, and implementing supply-side policies.
  • The euro was introduced in the EU on 1 January 2001. It was developed to lower the trading costs between countries.

Sources

1. Michael D. Bordo and Finn Kydland, Gold Standard as a Rule, 1990.

Exchange Rate

Interest rates influence currency exchange rates in regards to currency appreciation and depreciation. For example, increased interest rates influence the currency to appreciate because higher interest rates mean that it will be more favourable for people to save and this will also attract foreign investment. Due to this, demand for currency and its value will increase or appreciate.

The euro currency follows the free floating exchange rate system, this means that the euro's exchange rate can change depending on the currency supply and demand in the Forex market.

The exchange rate is the rate at which one foreign currency is exchanged for another.

Firstly, we need to know the current exchange rate of a foreign currency to the domestic currency. Then, to calculate the exchange rate for a particular amount, we need to divide that amount in a foreign currency by its exchange rate to the domestic currency. 

Exchange rates can affect businesses in different ways. For example, due to the quickly changing exchange rates in the floating system, companies will be unaware of how much they have to pay for imports or receive from exports, which will raise uncertainty in regards to international trade. 


On the other hand, the fixed exchange rate system may be favourable for international imports and exports as the currency exchange rate will always stay the same. This means that when businesses import goods they do not have to be concerned about higher import prices in regards to currency exchange rates. 

Final Exchange Rate Quiz

Question

What is a fixed exchange rate system? 

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Answer

A fixed exchange rate system is where the rate is fixed or set up through government intervention. Either the government or the central bank decides and sets the exchange rate. 

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How is the target rate determined in a fixed exchange rate? 

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Answer

This target rate could depend on the economic goals or objectives being pursued by the government through trade or foreign exchange. 

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What are the other terms for the 'target rate'?

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Answer

The exchange rate fixed by the central bank or the government is the target rate and is also called 'central peg' or 'central rate', 'parity' or 'par value'. 

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Question

What is 'ceiling' and 'floor' in a fixed exchange rate system? Explain with an example. 


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Answer

The ceiling is the upper limit while the floor is the lower limit in an exchange rate system. For example, if the government decides the central rate on 1.5 euros, the ceiling rate could be 1.55 euros while the floor rate could be 1.45 euros. 

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Question

What is the role of the foreign exchange market in a fixed exchange rate system? 

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Answer

Once the government or the central bank have fixed the exchange rate along with its upper and lower limits, it is left to fluctuate in the foreign exchange market freely. It is not tempered until it stays within the exchange rate band. 

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Question

What are two ways used to bring the exchange rate back within the exchange rate band (ceiling to floor) determined by the government or the central bank, if and when breached? 


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Answer

The two ways used are exchange equalization which is buying or selling its own currency and manipulation of the domestic interest rate in the economy.

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Question

What does the central bank do, in case of exchange equalization, if the exchange rate crosses the ceiling rate? 

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Answer

Sell its own currency

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How does the central bank use its official foreign reserves if the exchange rate drops below the floor rate? 

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Answer

To bring the exchange rate above the floor rate, the central bank buys its own currency in the foreign exchange market. 

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Question

What role do the domestic interest rates play in maintaining the exchange rate in a fixed exchange rate system? 

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Answer

In the case of intervention through interest rates, if the exchange rate crosses the ceiling rate, lowering interest rates might trigger international holders of domestic currency to sell it in the Forex market. If the exchange rate drops below the floor rate, then increasing interest rates will attract investment into the country's currency and this will likely push the exchange rate up to a point where it is within the exchange rate band. 

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Question

What is the downside to using interest rates in maintaining the exchange rate in a fixed exchange rate system? 

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Answer

When interest rates are used to maintain the exchange rate in a fixed exchange rate system, they cannot be used for any other domestic macroeconomic objectives such as low unemployment or economic growth. 

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Question

What is the exchange rate? 

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Answer

The exchange rate is the rate at which one foreign currency is exchanged for another.

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Question

Can you give an example of the exchange rate? 

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Answer

If currently £1 is worth €1.17, then for every £1 you will receive €1.17. This gives an exchange rate of £1 = €1.17. 

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Question

What is the freely floating exchange rate?

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Answer

The freely floating exchange rate is the currency exchange rate that is determined by the supply and demand of a currency. As a result, exchange rates that follow this system are likely to fluctuate based on currency exchanges in the forex market.

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Question

What is another word used for the foreign exchange market? 

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Answer

Forex market.

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Question

What is the fixed exchange rate?

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Answer

The exchange rate in the fixed system is the policy that is established by a government or central banks regarding the currency exchange rate. In this system, central banks or the government create the value of the currency at its fixed-rate when exchanging it for another currency. 

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Question

Can you give an example of a fixed exchange rate? 

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Answer

For example, the bank of England can announce the British pound exchange rate to the US dollar at the rate of US $1.50. This rate remains fixed under the fixed exchange rate system.

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What is the 'fixed exchange rate' also known as? 

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Answer

This fixed exchange rate is known as 'central peg', 'central rate', 'parity' or 'par value'.

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Question

What is the semi-fixed exchange rate?

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Answer

The semi-fixed exchange rate refers to the exchange rate between two currencies that is allowed to fluctuate within a set range, which lies between the 'price ceilings' and 'price floors'. Central banks usually determine semi-fixed exchange rates.  

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Question

What are 'price ceilings'?

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Answer

Price ceilings are usually set by central banks and they refer to the highest fixed rate at which currency can be exchanged for another in the semi-fixed system. 

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Question

What are 'price floors'?

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Answer

Price floors are usually set by central banks and they refer to the lowest fixed rate at which one currency can be exchanged for another in the semi-fixed system. 

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Question

What is a managed exchange rate system? 

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Answer

Exchange rates in the managed system are influenced by the markets and government interventions of buying and selling currencies or making some adjustments to monetary policies. 

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Question

What is the adjustable peg exchange rate?

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Answer

Adjustable peg exchange rates lean toward fixed exchange rates system but remain managed.

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Question

What is the historical exchange rate?

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Answer

The fixed exchange rate can be also identified as a historical exchange rate as it was one of the first exchange rate systems and it was introduced as the ‘gold standard’ which was first adopted by England in 1717.  The ‘gold standard’ system was created to establish currencies fixed exchange rates to gold. The exchange rate reflects on the value of the currency, the more valuable the currency was the fewer units it needed to purchase gold.

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Question

In which currency exchange rate system government intervene the least?

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Answer

 In the floating system, the government has the least involvement to intervene or influence currency exchange rates in comparison to other exchange rate systems. 

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Question

What are the key methods used by the government to influence exchange rates?

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Answer

The key methods that the government use to influence exchange rates are: 

  • Buying or selling foreign exchange reserves
  • Borrowing, increasing interest rates
  • Increasing inflation
  • Implementing supply-side policies

Show question

Question

What is the euro?

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Answer

The euro is the common currency used within the EU also known as a currency union or monetary union.  

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Question

What is the key advantage of joining a currency union?

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Answer

The advantages of the currency union are:

Transfer of wealth - As a result of common fiscal policy in the currency union, wealth is transferred from the richer parts of the union to the poorer parts. As a result, the poorer parts of the union will see economic improvements. 

Improving competitiveness in the poorer regions - The implementation of fiscal transfers in the common union allows richer countries to transfer funds to poorer countries to restore their competitiveness and reduce inequality.

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Question

What can the floating exchange rate best be used for?  

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Answer

The floating exchange rate can be best used to:

  • Reflect the true currency value
  • Instead of using time and resources to manage the exchange rate government can instead focus on domestic objectives, such as controlling inflation and reducing unemployment. 

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Question

What can the fixed exchange rate best be used for?  

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Answer

The fixed exchange rate can be best for:

  • Businesses, as they can be certain about the prices of imports and exports.
  • The fixed exchange rate can encourage investment as firms will be certain about exchange rates.

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Question

What are the three different types of exchange rates?

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Answer

  1. Floating exchange rate 
  2. Fixed exchange rate
  3. Managed exchange rate

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Question

Define a floating exchange rate.

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Answer

A free floating exchange rate system is one where the government does not intervene, whatsoever, in determining the exchange rate.

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Define a managed exchange rate. 

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A managed exchange rate system is an exchange rate system where demand and supply value the currency and its exchange rate but the government or central bank can intervene.

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Question

What is a managed exchange rate also known as?

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Answer

Dirty float

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Question

Define depreciation. 

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Answer

Depreciation of a currency refers to a fall in the value of a currency due to free market forces.

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Define appreciation.

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Answer

Appreciation of a currency refers to a rise in the value of a currency due to free market forces.

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Question

What values a floating exchange rate system?

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Answer

Free market forces

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What are the main free market determinants?

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Answer

  1. Trade
  2. Investment
  3. Speculation

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What fluctuations in the free market can influence a floating exchange rate?

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Answer

  • Inflation rates
  • Interest rates
  • Economic growth

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Question

What fluctuations in the free market can influence a managed exchange rate?

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Answer

The government and other authorities.

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Question

Name two countries with a floating exchange rate system.

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Answer

Any two from:

  • Australia
  • Canada
  • Japan
  • Chile 
  • Mexico 
  • US 

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Question

What are some advantages of a floating exchange rate?

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Answer

  • Partial correction for a current account deficit. 
  • No government effort or intervention. 
  • Freedom to set monetary policyinterest rates. 
  • Reduces the need for large currency reserves. 

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Question

What are some disadvantages of a floating exchange rate?

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Answer

  • Volatility.  
  • Instability. 
  • Doesn't correct a current account deficit if the Marshall Lerner condition is not met. 

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Question

The Marshall Lerner's condition states:

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Answer

A depreciation of the exchange rate will eventually lead to an improvement in the current account provided the the sum of the price elasticity of demand (PED) for exports and imports > 1.

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Question

What does the J curve show?

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Answer

The J curve shows that initially, the current account deficit will worsen because the Marshall Lerner's condition is not met in the short term. In the long term, the current account will improve as the condition holds true and consumers start to realise the gains in the change in the exchange rate.

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Question

State and explain two advantages of a fixed exchange rate system.

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Answer

Any two from:

  • Certainty. The stability of an exchange rate will increase both business and consumer confidence. This will encourage investment within the economy which will spur economic growth and development. Higher consumer confidence will lead to increased consumption and shift the aggregate demand (AD) curve outward.
  • Less speculation. A fixed exchange rate will have to operate within its bands if it is be successful. Because of this, speculation around this currency would be relatively less compared to it were a floating exchange rate. Less speculation reduces the concerns of the value of a currency being wiped out in a day. 
  • Economic management. The wider economy can be better managed with a fixed exchange rate. It helps keeps prices low, improves stability and confidence. Having all of this in controls, helps manage the economy.

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Question

State and explain two disadvantages of a fixed exchange rate system.

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Answer

Any two from:

  • Inflation. Every time a devaluation of the exchange rate occurs, it can lead to cost push inflation. Inflation can erode any competitiveness firms in the export industry may have.
  • Less freedom and flexibility. A fixed exchange rate reduces the freedom governments have to use their interest rates. Altering interest rates is a key instrument the government use to respond to shocks, or for other macroeconomic objectives.
  • Wrong rate. It is difficult to know which rate to fix the exchange rate at. If the rate is too high, exports will be less competitive which will impact the export sector. If the rate is too low, this will lead to inflation.

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Question

Name three countries with an exchange rate tied to a single currency.

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Answer

Any three from:

  1. Aruba.
  2. The Bahamas.
  3. Bahrain.
  4. Hong Kong.
  5. Iraq.
  6. Saudi Arabia. 

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Question

Name two countries with an exchange rate tied to a basket of foreign currencies instead of a single currency.

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Answer

Any two from:

  1. Libya.
  2. Fiji.
  3. Morocco.
  4. Kuwait.

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Question

What is the primary aim of a fixed exchange rate?

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Answer

The primary aim of fixing an exchange rate is creating stability and certainty for exporters, importers, investors and consumers.

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