fig

Currency Exchange between nations

3.2 A: Floating Exchange Rates

The Foreign Exchange Market

An exchange rate is the value of one currency expressed in terms of another currency.

Currency is exchanged in the international Foreign Exchange Market. (FOREX)

Extra interesting infoThe foreign exchange market (and

commonly abbreviated as forex or simply ‘FX’) is the largest, most liquid, most actively traded financial market in the world.

With an estimated four and half trillion dollars of value being traded everyday, the foreign exchange market is a decentralized network of financial institutions where all the world’s currencies are traded.

Currency transactions can take place from various locations around the world. One location doesn’t have authority over another.

Price of NZD in

USD

Amount of NZD

S

D

In a free floating system: demand and supply forces determine the exchange rate

0.71

The demand for a currency is derived from: Any money flow into one country from another

country.

Current account inflows Exports of goods and services Investment income earned

Capital account inflows Foreign Investment (of a nation’s shares or

assets) Buying a nation’s currency chasing either:

Higher interest rates Speculation of higher exchange rates

The supply of a currency is derived from any flow out of a country into another in order to

buy…

Current account outflows Imports of goods and services Investment income earned from abroad

Capital account outflows Foreign Investment (buying foreign shares or

assets) Buying foreign currency (hot money), chasing

either: Higher interest rates Speculation of higher exchange rates

A floating exchange rate system allows its currency to be valued according to the demand and supply in the forex (without government intervention).

For example: when NZ imports cars from Japan…

JapanNew ZealandFOREX

IMPORT PAYMENTS

EXPORT RECEIPTS

TWO WAYS FOR a currency TO APPRECIATE

NZD/USD

S1

D

Q of NZD

D1

S

fig

1.75

2.00

2.25

2.50

2.75

3.00

0

TWO WAYS FOR a currency TO DEPRECIATEPr

ice

of E

UR

O in

NZD

Quantity of EURO

S1

D1

S2

D2

Depreciation

Time-dependent determinantsfor currencies

in the short-run, “hot money” – chasing high interest rates – far exceed trade flows

in the medium term, a consistent current account surplus/deficit will lead to a currency movement.

Think: which will lead to an appreciation?in the long run, inflation rates will lead to a

currency movement. Think: which will lead to an appreciation?

Pairs competition!

Gives clues (e.g. Examples) of any international money flow

The other team must correctly identify the impact on supply or demand, and the impact on the X∆R

(You may refer to either a specific item, or account and or state the direction of money flow)

Grade A task: report on current pressures affecting the exchange rate of any

country

Look for: imbalances in the B/P accounts? upcoming pressures? What’s your 12-month forecast? check out http://www.xe.com

fig

3.2 B Fixed Exchange RatesHow do they do it?

What is a fixed exchange rate system?

A fixed exchange rate is a system where the value of the currency is fixed (pegged) to the value of another currency.

to “revalue” means to adjust the currency upwards

to “devalue” means to adjust it downwards

A managed” system is where the government occasionally intervenes to keep the currency from fluctuating too much.

Essentially, the pressures on Supply or Demand of the currency must be counter-acted.

1. The central bank can sell (supply) more of its currency on the Forex (and thus increase foreign reserves). This is the response when the currency is… Or buy its currency (using its foreign reserves)

(and borrow from the IMF if it’s a crisis.) This is the response when the currency is…

2. Adjust interest rates. How will this work?

How can a currency be fixed?

how could a government counter these forces?

NZD/USD

S1

D

Q of NZD

D1

S

Current exchange rate regimes

dark green - free float regime, light green - Managed float regime, blue - different types of fixed currency (peg)http://en.wikipedia.org/wiki/File:Currency_Exchange_regimes.png