Foreign Exchange Rates (Copy)
6.3 Foreign Exchange Rates
6.3.1 Definition of Foreign Exchange Rate
- The foreign exchange rate is the price of one currency expressed in terms of another.
- Example: If 1 US dollar = 280 Pakistani rupees, then the exchange rate is 1 USD = 280 PKR.
6.3.2 Determination of Foreign Exchange Rate in the Foreign Exchange Market
- Exchange rates are determined by demand and supply of currencies.
- Demand for a currency comes from:
- Foreigners buying a country’s exports.
- Foreigners investing in the country.
- Speculators expecting the currency to rise.
- Supply of a currency comes from:
- Domestic residents importing goods.
- Domestic investors buying foreign assets.
- Speculators expecting the currency to fall.
- Equilibrium exchange rate is set where demand = supply in the forex market.
Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Economics Full Scale Course
6.3.3 Causes of Foreign Exchange Rate Fluctuations
- Changes in demand for exports/imports: Higher demand for exports raises demand for domestic currency.
- Changes in interest rates: Higher rates attract foreign investment, increasing demand for the currency.
- Speculation: If investors expect the currency to rise, demand increases.
- Entry/exit of MNCs: Multinationals investing in a country increase demand; withdrawing decreases demand.
- Capital flows: Large-scale movement of money between countries.
- Political/economic stability: Instability causes depreciation as investors move money out.
6.3.4 Consequences of Foreign Exchange Rate Fluctuations
- Depreciation (fall in currency value):
- Exports become cheaper → demand rises.
- Imports become more expensive → demand falls.
- May worsen inflation if imports are essential (e.g., oil).
- Appreciation (rise in currency value):
- Exports become more expensive → demand falls.
- Imports become cheaper → demand rises.
- May reduce inflation but hurt export industries.
- Effect depends on PED (price elasticity of demand):
- If exports/imports are price inelastic, trade balance may worsen despite depreciation.
Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Economics Full Scale Course
6.3.5 Floating and Fixed Foreign Exchange Rates
- Floating Exchange Rate:
- Value determined by demand and supply in forex market.
- Advantages: Automatic adjustment, no need for government intervention.
- Disadvantages: High uncertainty, volatility can discourage investment.
- Fixed Exchange Rate:
- Government/central bank sets the exchange rate and maintains it using reserves.
- Advantages: Stability and certainty for traders and investors.
- Disadvantages: Requires large reserves, risk of black markets, may cause unemployment if rate is overvalued.
Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Economics Full Scale Course