floating-exchange-rate-systems

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Foreign Exchange Rates

An exchange rate is the price of one currency in terms of another e.g. £1 = €1.18
- International currencies are essentially products that can be bought & sold on the foreign exchange market (forex)
The Central Bank of a country controls the exchange rate system that is used in determining the value of a nation’s currency
Two of the main exchange rate systems used are:
- A floating exchange rate
- A fixed exchange rate

1. A Floating Exchange Rate System

The forces of demand and supply determine the rate at which one currency exchanges for another and there is no government intervention in the currency market

Different currencies can be bought and sold, just like any other product
As with any market, if there is excess demand for the currency on the forex market, then prices rise (the currency appreciates)
If there is an excess supply of the currency on the forex market, then prices fall (the currency depreciates)

Diagram: Floating Exchange Rates

Two economic graphs show currency exchange shifts. Left: US dollar appreciates. Right: Euro depreciates. Arrows indicate supply and demand changes. — **The relationship between the US$ and the Euro shows that as Europeans demand the $ it appreciates but by supplying their own currency it depreciates**

Diagram analysis

The Euro/US$ market is shown by two market diagrams – one for the USD market on the left and one for the Euro market on the right
The initial exchange rate equilibrium is found at P₁Q₁ in both markets
When Europeans visit the USA, they demand US$ and supply Euros
- The increased demand for the US$ shifts the demand curve to the right which results in the value of the $ appreciating from P₁ → P₂in the USD market and a new market equilibrium forms at P₂Q₂
- The increased supply of the Euro shifts the supply curve to the right which results in the value of the Euro depreciating from P₁ → P₂and a new market equilibrium forms at P₂Q₂

Floating exchange rate calculations

As the value of a currency appreciates or depreciates, the value of any international transaction changes
These changes can be significant for firms during times of exchange rate volatility

Worked Example

Marsha is a currency trader who buys and sells currency in order to make a profit. Currently, she is holding €200,000 and expects that the Pound will appreciate against the € in the next few months.

At present £1 = €1.10

Marsha exchanges her Euros for Pounds. Calculate the quantity of Pounds she will receive for €200,000 [1]
The Pound depreciates against the Euro by 10%. Fearing further depreciation, Marsha changes her Pounds back to Euros. Calculate the loss she has made.

Step 1: Calculate the quantity of Pounds received for €200,000

$begin mathsize 14px style fraction numerator 200 comma 000 over denominator 1.1 end fraction space equals £ 181 comma 818.18 end style$

Step 2: Calculate the new exchange rate

£1= (€1.10 x 0.9) = €0.99

Step 3: Use the above value to calculate the new amount of Euros

£181,818.18 x 0.99 = £179,999,9982

Step 4: Round to two decimal places

£180,000

Step 5: Calculate the loss

£200,000 – £180,000 = £20,000 loss

Evaluating Exchange Rate Systems

Each exchange rate system has advantages and disadvantages attached

An Evaluation of A Floating Exchange Rate Mechanism

Advantages	Disadvantages
Natural fluctuations in the exchange rate based on demand and supply help to maintain stable current account balances If a currency appreciates, the country’s exports fall and imports rise If a currency depreciates, the country’s exports rise and imports fall	Fluctuations in the exchange rate can create uncertainty for firms, leading to a reduction in investment E.g. if a firm provides a quotation to a foreign buyer based on today’s exchange rate, but the exchange rate then appreciates, the domestic firm will not make as much profit as expected
Currency appreciation may allow costs of imported raw materials to decrease, which may help lower prices in the economy	Currency depreciation may cause costs of imported raw materials to increase, resulting in cost push inflation
Lower exchange rates (or a depreciating currency) may help to increase economic growth as export sales increase	Higher exchange rates (or an appreciating currency) may reduce/slow down economic growth as export sales decrease
Government does not need to monitor and maintain a fixed exchange rate

Economics-A-level-Aqa