Foreign Exchange Rates (Copy)

6.3.1 Definition of Foreign Exchange Rate

• Foreign exchange rate = the price of one currency expressed in terms of another.
  • Example: 1 USD = 280 PKR means one US dollar can be exchanged for 280 Pakistani rupees.
• Determined in the foreign exchange market, where currencies are bought and sold.
• Important for:
  • Consumers (affects cost of imported goods).
  • Firms (affects competitiveness of exports and imports).
  • Governments (influences trade balance and inflation).

Diagram: Exchange Rate Concept

1 USD = 280 PKR
↑ USD value → imports cheaper in PKR
↓ USD value → exports cheaper in foreign markets

6.3.2 Determination of Foreign Exchange Rate in Foreign Exchange Market

• Exchange rate determined by demand and supply of a currency.
• Demand for a currency arises from:
  • Foreigners buying a country’s exports.
  • Tourists visiting that country.
  • Foreign investors purchasing assets.
  • Speculators expecting currency to rise.
• Supply of a currency arises from:
  • Citizens importing foreign goods.
  • Tourists travelling abroad.
  • Domestic investors investing overseas.
  • Speculators expecting currency to fall.

Diagram: Currency Market

Price of currency (exchange rate)
     ^
     |    D1
     |     
     |      
     |       
     |-----------------
     |           D2 (shift in demand)
     |
     +--------------------> Quantity of currency

Equilibrium = where Demand = Supply

• A rise in demand shifts D1 → D2, raising exchange rate (appreciation).
• A fall in demand shifts curve left, lowering exchange rate (depreciation).

6.3.3 Causes of Foreign Exchange Rate Fluctuations

1. Changes in demand for exports/imports
   • If exports rise → more foreign buyers need domestic currency → appreciation.
   • If imports rise → more demand for foreign currency → depreciation.
2. Changes in interest rates
   • Higher interest rates → attract foreign investment → more demand for domestic currency → appreciation.
   • Lower interest rates → outflow of capital → depreciation.
3. Speculation
   • If investors expect a currency to strengthen → they buy now → demand rises → appreciation.
   • If they expect it to weaken → they sell → supply rises → depreciation.
4. Entry/exit of MNCs
   • MNCs entering a country → bring foreign capital → appreciation.
   • MNCs leaving → capital outflow → depreciation.
5. Political/economic stability
   • Stable governments attract investors → appreciation.
   • Instability causes capital flight → depreciation.

6.3.4 Consequences of Foreign Exchange Rate Fluctuations

• Depreciation (fall in currency value):
  • Exports cheaper abroad → demand for exports rises (depends on PED).
  • Imports more expensive → consumers buy fewer imports.
  • Trade balance may improve.
  • But → higher import costs = inflation risk (imported raw materials, oil).
• Appreciation (rise in currency value):
  • Exports more expensive abroad → demand for exports falls.
  • Imports cheaper → more imports.
  • Trade balance may worsen.
  • Consumers benefit (cheaper imports), but exporters may suffer.

Diagram: Effects of Depreciation

Currency Depreciation →
   Exports ↑ (cheaper)
   Imports ↓ (expensive)
   → Trade Balance improves

6.3.5 Floating and Fixed Foreign Exchange Rates

1. Floating Exchange Rate System
   • Exchange rate determined by market forces of demand and supply.
   • Government does not intervene.

   Advantages:

   • Automatic adjustment of trade imbalances.
   • No need for large reserves of foreign currency.
   • Protects economy from external shocks.

   Disadvantages:

   • High volatility creates uncertainty for firms (planning exports/imports).
   • Inflation risk if currency depreciates sharply.
   • Speculative attacks can destabilise currency.
2. Fixed Exchange Rate System
   • Exchange rate pegged to another currency or basket of currencies.
   • Government intervenes (buying/selling currency, controlling capital flows, adjusting interest rates).

   Advantages:

   • Stability encourages investment and trade.
   • Reduces uncertainty for exporters/importers.
   • Helps control inflation (if tied to stable currency).

   Disadvantages:

   • Requires large reserves of foreign currency.
   • Difficult to maintain if market pressures are strong.
   • Can lead to black markets if exchange rate is unrealistic.

Diagram: Floating vs Fixed

Floating: Rate moves with supply & demand
Fixed: Government keeps rate at set value