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Exchange Rates

Exchange Rates. The Global Economy. Aims. In this lesson you will: Be able to define exchange rates. Identify the different types of exchange rates. Identify the demand and supply of currency. The economic effects of exchange rate movements. Objectives.

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Exchange Rates

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  1. Exchange Rates The Global Economy

  2. Aims • In this lesson you will: • Be able to define exchange rates. • Identify the different types of exchange rates. • Identify the demand and supply of currency. • The economic effects of exchange rate movements.

  3. Objectives • All students to be able to define exchange rates. All students to identify what factors effect supply and demand for currency. • Most students to identify and explain the economic effects of exchange rates. • A few students to be able to explain changes in the Exchange rate in a diagram format.

  4. Further reading A2 Textbook Web Links • http://www.economicsonline.co.uk/Global_economics/Exchange_rates.html • http://tutor2u.net/business/gcse/external_environment_economic_exchange_rates.htm • Text Book 254

  5. Exchange Rates • The exchange rate is the price of one currency in terms of another. • It is determined by the demand and supply of currencies on the foreign exchange markets (FOREX)

  6. Importance • Exchange rates represent a cost to firms, which arises when commission is paid on the exchange of one currency for another. • Exchange rate changes create a risk to those firms that hold assets in currencies other than Sterling. • Exchange rates affect the price of exports, which form a significant part of aggregate demand, and the price of imports, and hence the balance of payments.

  7. Types of Exchange Rates • Floating • Fixed • Managed

  8. Supply and demand of currencies Demand Supply • Exports of goods • Export of services • Inflows of direct investment • Imports of goods • Imports of services • Outflows of direct investment

  9. Increase in demand • If there is an increase in demand for the pound, due to a surge in exports to the USA, there will be an upward pressure on the value of the exchange rate.

  10. Changes in demand The equilibrium exchange rate for the pound and the US dollar is at price P, where supply and demand for sterling are equal. If there is an increase in demand for the pound, due to a surge in exports to the USA, there will be upward pressure on the value of the exchange rate. Conversely, if there is a fall in demand for sterling, perhaps due to a fall in foreign direct investment from the USA. $s per £ S P1 P P2 D1 D D2 0 Q2 Q Q1 Quantity

  11. Changes in Supply An increase in the Value of pound, due to a rise in imports from the USA, will apply downward pressure on the value of the currency. Conversely, if there is a fall in supply for Sterling, perhaps due to a fall in speculative selling of the currency, the supply of Sterling will shift from S to S2 and the currency will appreciate from P to P2. $s per £ S2 S S1 P2 P P1 D 0 Q2 Q Q1 Quantity

  12. Hot Money • If a nations interest rate increases, and are higher than other countries, there is likely to be an inflow of Hot Money. • An inflow of Hot Money will boost the demand for the currency and cause an appreciation in the exchange rate.

  13. Video • http://www.youtube.com/watch?v=xwtgByffoUw&feature=related

  14. Economic Effects Exchange Rates

  15. Economic Effects • A depreciation in the value of sterling will have wide ranging economic effects, impacting on the four main indicators. • Inflation • Economic Growth • Unemployment • Balance of Payments

  16. Exports • Exports should benefit from a fall of the value of the pound. • The demand for exports is determined by the foreign price elasticity of demand for UK goods. • Export firms may decide to hold export prices constant and increase their profit margins.

  17. Imports • A depreciation in Sterling will make imports more expensive and, as a result, the demand for imports should fall.

  18. Balance of Payments • A depreciation will improve the current account balance. • The demand for imports will fall, and the demand for exports will rise.

  19. Inflation • A fall in the exchange rates increases prices in the UK. • Higher prices for imported components and raw material will lead to cost push inflation. • Higher exports and falling imports will increase aggregate demand and cause demand pull inflation.

  20. Economic growth and employment • Higher export and falling imports will increase aggregate demand and GDP. • A rise in aggregate demand should reduce demand deficient unemployment.

  21. The Euro Advantages Disadvantages • Trade Creation • More efficient • Price transparency • Increase competitiveness • Trade diversion • Loss of control over monetary policy • Fiscal policy constraints

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