The exchange rate is the rate at which one currency trades against another on the foreign exchange market.
Key Terms in Foreign Exchange Rate
- Fixed Exchange Rate System: This exists when the central bank buys and sells foreign currencies to ensure the value of its currency stays at the pegged value.
- Devaluation: This occurs when the price of a currency operating in a fixed exchange rate system is officially and deliberately lowered.
- Revaluation: This occurs when the price of a currency operating in a fixed exchange rate system is officially and deliberately increased.
- Floating Exchange Rate System: This means that currency can fluctuate against other currencies according to market forces.
- Appreciation: Appreciation of a currency occurs when there is an increase in its value relative to another currency operating in a floating exchange rate system.
- Depreciation: This occurs when there is a fall in its value relative to another currency operating in a floating exchange rate.
Causes of Foreign Exchange Rate in market situation
- Changes in demand for exports: an increase in demand for exports due to improved quality or successful advertising will increase the demand for the country’s currency, this therefore increases exchange rate.
- Change in demand for imports: an increase in demand for imports due to an increase in competitiveness of foreign firms will raise the value of the foreign currency in order to facilitate the purchase of foreign goods and services.
- Prices & Inflation: an increase in the prices of goods & services caused by domestic inflation will tend to decrease the demand for exports. This will therefore cause the exchange rate to fall in value.
- Foreign direct investment: Expansion of MNCs mean that investment in overseas plants requires the use of foreign currencies. This will boost the demand for a currency.
- Speculation: Forex traders move money around the world to take advantage of higher interest rates. Speculators might also lack interest in some economies and withdraw their investments there by depreciating the currency.
Consequences of Foreign Exchange Rate Fluctuations
Effects on Micro Economy
- Consumers: they will have reduced purchasing power if their currency depreciates, this can also happen otherwise.
- Exporters: They face more difficult trading conditions when the exchange rate increases owing to the fact that their output will become more expensive for foreign customers which will lead to a fall in demand.
- Importers: They potentially gain from a strong currency as it makes it easy for them to import raw materials and other materials from other countries.
Effects on Macro Economy
- Balance of Payment: if a currency appreciation has a larger impact on exports than imports, then BOP will worsen, this is because a strong currency will make it difficult for exporters to sell in overseas market.
- Employment: a fall in net exports and dropping profits will cause job losses in export-oriented businesses which will lead to cyclical unemployment.
- Inflation: If a country relies heavily on imported good supplies, the lower the exchange rate will increase the general price level as a result of the depreciation in currency.