EXCHANGE RATE

PIOTR PIETRASZEWSKI
EXCHANGE RATE - DEFINITION

 the price of one currency in terms of another currency

 the number of units of one currency that can be exchanged into
(purchased with or sold for) one unit of the another currency
EXCHANGE RATE - DEFINITION

 the price of one currency in terms of another currency

 the number of units of one currency that can be exchanged into
(purchased with or sold for) one unit of the another currency

Two types of quotations:

DIRECT
 the price of the foreign currency in terms of domestic currency
 the number of units of the domestic currency that can be
exchanged into one unit of foreign currency
EXCHANGE RATE - DEFINITION

 the price of one currency in terms of another currency

 the number of units of one currency that can be exchanged for
(purchased with or sold for) one unit of the another currency

Two types of quotations:

DIRECT
 the price of the foreign currency in terms of domestic currency
 the number of units of the domestic currency that can be
exchanged for one unit of foreign currency

INDIRECT
 the price of the domestic currency in terms of foreign currency
 the number of units of the foreign currency that can be exchanged
for one unit of domestic currency
EXCHANGE RATE REGIME

Exchange rate regime – a description of the conditions under

which economic authorities allow exchange rates to be determined

The two extreme cases:

 FIXED (MANAGED) EXCHANGE RATE REGIME

 FLEXIBLE (FLOATED) EXCHANGE RATE REGIME

EXCHANGE RATE (EXTREME) REGIMES

FIXED (MANAGED) EXCHANGE RATE REGIME

 the economic authority of the country regulates the rate at which

its currency is exchanged for other currencies
 economic authority agrees to maintain the convertibility of their
currency at a fived exchange rate

a currency is convertible if the economic authority (central bank)

agrees to buy or sell as much of the currency as people wish to
trade at a fixed rate
EXCHANGE RATE (EXTREME) REGIMES

FLEXIBLE (FLOATED) EXCHANGE RATE REGIME

 the economic authority doesn’t interfere in the valuation of the

currency in any way (no official reserve transactions)
 the exchange rate is allowed to attain its free market equilibrium
level
 the value of currency changes due to the fluctuations in the
demand and supply of the currency
DEMAND AND SUPPLY OF CURRENCY

The demand of foreign residents for the currency of some

country is induced mainly by:

 the purchases of goods and services produced in this country

(credits in CuA)
 the purchases of assets denominated in the currency of this
country (credits in FA)
DEMAND AND SUPPLY OF CURRENCY

The demand of foreign residents for the currency of some

country is induced mainly by:

 the purchases of goods and services produced in this country

(credits in CuA)
 the purchases of assets denominated in the currency of this
country (credits in FA)

realized demand for local currency = export of goods, services

and assets
DEMAND AND SUPPLY OF CURRENCY

The supply of the currency of some country is induced mainly by:

 the purchases of goods and services produced in other countries

(debits in CuA)
 the purchases of assets denominated in the currencies of other
countries (debits in FA)
made by the residents of this country.
DEMAND AND SUPPLY OF CURRENCY

The supply of the currency of some country is induced mainly by:

 the purchases of goods and services produced in other countries

(debits in CuA)
 the purchases of assets denominated in the currencies of other
countries (debits in FA)
made by the residents of this country.

realized supply of local currency = import of goods, services and

assets
WHY DOES THE DEMAND GO DOWN AND THE
SUPPLY GO UP WITH THE INCREASE OF THE
EXCHNGE RATE?
Let’s assume that prices of goods in the UK and the USA are fixed.
WHY DOES THE DEMAND GO DOWN AND THE
SUPPLY GO UP WITH THE INCREASE OF THE
EXCHNGE RATE?
Let’s assume that prices of goods in the UK and the USA are fixed.

 When the exchange rate (USD/GBP) goes up, dollar prices of UK

goods gets higher which reduces export from the UK and the
demand for £
(both its quantity and value in £)
WHY DOES THE DEMAND GO DOWN AND THE
SUPPLY GO UP WITH THE INCREASE OF THE
EXCHNGE RATE?
Let’s assume that prices of goods in the UK and the USA are fixed.

 When the exchange rate (USD/GBP) goes up, dollar prices of UK

goods gets higher which reduces export from the UK and the
demand for £
(both its quantity and value in £)

 When the exchange rate (USD/GBP) goes up, goods produced in the
USA get cheaper for Britains. It stimulates the quantity of UK
import but not necessarily its value in £ (Britains have to pay less £
for the same goods from the USA) and hence the supply of £.
WHY DOES THE DEMAND GO DOWN AND THE
SUPPLY GO UP WITH THE INCREASE OF THE
EXCHNGE RATE?
Let’s assume that prices of goods in the UK and the USA are fixed.

 When the exchange rate (USD/GBP) goes up, dollar prices of UK

goods gets higher which reduces export from the UK and the
demand for £
(both its quantity and value in £)

 When the exchange rate (USD/GBP) goes up, goods produced in the
USA get cheaper for Britains. It stimulates the quantity of UK
import but not necessarily its value in £ (Britains have to pay less £
for the same goods from the USA) and hence the supply of £.
Whether it increases the number of £ spent for the USA goods
depends on the elasticity of British import.
WHY DOES THE DEMAND GO DOWN AND THE
SUPPLY GO UP WITH THE INCREASE OF THE
EXCHNGE RATE?
Let’s assume that prices of goods in the UK and the USA are fixed.

 When the exchange rate (USD/GBP) goes up, dollar prices of UK

goods gets higher which reduces export from the UK and the
demand for £
(both its quantity and value in £)

 When the exchange rate (USD/GBP) goes up, goods produced in the
USA get cheaper for Britains. It stimulates the quantity of UK
import but not necessarily its value in £ (Britains have to pay less £
for the same goods from the USA) and hence the supply of £.
Whether it increases the number of £ spent for the USA goods
depends on the elasticity of British import.

We assume that import is price-elastic enough to stimulate its value

in £ and hence the supply of £.
EXCHANGE RATE REGIMES AND THE
EQUILIBRIUM OF BOP

 Under floating exchange rate system the BOP equilibrium is

achieved automaticly by exchange rate changes
EXCHANGE RATE REGIMES AND THE
EQUILIBRIUM OF BOP

 Under floating exchange rate system the BOP equilibrium is

achieved automaticly by exchange rate changes

demand for local currency = supply of local currency

EXCHANGE RATE REGIMES AND THE
EQUILIBRIUM OF BOP

 Under floating exchange rate system the BOP equilibrium is

achieved automaticly by exchange rate changes

demand for local currency = supply of local currency

export of the domestic goods, services and assets =

= import of foreign goods, services and assets
EXCHANGE RATE REGIMES AND THE
EQUILIBRIUM OF BOP

 Under floating exchange rate system the BOP equilibrium is

achieved automaticly by exchange rate changes

demand for local currency = supply of local currency

export of the domestic goods, services and assets =

= import of foreign goods, services and assets

export - import of goods and services = import - export of assets

EXCHANGE RATE REGIMES AND THE
EQUILIBRIUM OF BOP

 Under floating exchange rate system the BOP equilibrium is

achieved automaticly by exchange rate changes

demand for local currency = supply of local currency

export of the domestic goods, services and assets =

= import of foreign goods, services and assets

export - import of goods and services = import - export of assets

CuA ballance = - (nonreserve) FA balance

THE MECHANISM OF RESTORING
EQUILIBRIUM IN THE BOP UNDER
FLOATING EXCHANGE RATE REGIME
surplus in BOP deficit in BOP
THE MECHANISM OF RESTORING
EQUILIBRIUM IN THE BOP UNDER
FLOATING EXCHANGE RATE REGIME
surplus in BOP deficit in BOP

export of domestic G, S & A > export of domestic G, S & A <

import of foreign G, S & A import of foreign G, S & A
THE MECHANISM OF RESTORING
EQUILIBRIUM IN THE BOP UNDER
FLOATING EXCHANGE RATE REGIME
surplus in BOP deficit in BOP

export of domestic G, S & A > export of domestic G, S & A <

import of foreign G, S & A import of foreign G, S & A
demand for local currency > demand for local currency <
supply of local currency supply of local currency
THE MECHANISM OF RESTORING
EQUILIBRIUM IN THE BOP UNDER
FLOATING EXCHANGE RATE REGIME
surplus in BOP deficit in BOP

export of domestic G, S & A > export of domestic G, S & A <

import of foreign G, S & A import of foreign G, S & A
demand for local currency > demand for local currency <
supply of local currency supply of local currency
the exchange rate is the exchange rate is overvalued
undervalued
THE MECHANISM OF RESTORING
EQUILIBRIUM IN THE BOP UNDER
FLOATING EXCHANGE RATE REGIME
surplus in BOP deficit in BOP

export of domestic G, S & A > export of domestic G, S & A <

import of foreign G, S & A import of foreign G, S & A
demand for local currency > demand for local currency <
supply of local currency supply of local currency
the exchange rate is the exchange rate is overvalued
undervalued

the exchange rate rises the exchange rate falls

THE MECHANISM OF RESTORING
EQUILIBRIUM IN THE BOP UNDER
FLOATING EXCHANGE RATE REGIME
surplus in BOP
export of domestic G, S & A >
import of foreign G, S & A
demand for local currency >
supply of local currency
the exchange rate is
undervalued
the exchange rate rises
it restores equilibrium in the
BOP
deficit in BOP
export of domestic G, S & A <
import of foreign G, S & A
demand for local currency <
supply of local currency
the exchange rate is overvalued
the exchange rate falls
it restores equilibrium in the
BOP
EXCHANGE RATE REGIMES AND THE
EQUILIBRIUM OF BOP

 Under fixed exchange rate system the BOP is balanced by official

reserve transactions of the econimic authorities
FIXED EXCHANGE RATE REGIME AND
THE BOP

surplus in BOP deficit in BOP

FIXED EXCHANGE RATE REGIME AND
THE BOP

surplus in BOP deficit in BOP

export of domestic G, S & A > export of domestic G, S & A <

import of foreign G, S & A import of foreign G, S & A
FIXED EXCHANGE RATE REGIME AND
THE BOP

surplus in BOP deficit in BOP

export of domestic G, S & A > export of domestic G, S & A <

import of foreign G, S & A import of foreign G, S & A
demand for local currency > demand for local currency <
supply of local currency supply of local currency
FIXED EXCHANGE RATE REGIME AND
THE BOP

surplus in BOP deficit in BOP

export of domestic G, S & A > export of domestic G, S & A <

import of foreign G, S & A import of foreign G, S & A
demand for local currency > demand for local currency <
supply of local currency supply of local currency
the exchange rate is the exchange rate is overvalued
undervalued
FIXED EXCHANGE RATE REGIME AND
THE BOP
surplus in BOP
export of domestic G, S & A >
import of foreign G, S & A
demand for local currency >
supply of local currency
the exchange rate is
undervalued
CB has to sell local currency for
the foreign currency
deficit in BOP
export of domestic G, S & A <
import of foreign G, S & A
demand for local currency <
supply of local currency
the exchange rate is overvalued
CB has to buy local currency for
the foreign currency
FIXED EXCHANGE RATE REGIME AND
THE BOP
surplus in BOP
export of domestic G, S & A >
import of foreign G, S & A
demand for local currency >
supply of local currency
the exchange rate is
undervalued
CB has to sell local currency for
the foreign currency
official reserve assets increase
deficit in BOP
export of domestic G, S & A <
import of foreign G, S & A
demand for local currency <
supply of local currency
the exchange rate is overvalued
CB has to buy local currency for
the foreign currency
official reserve assets decrease
EXERCISES
 When economic authority (central bank) of a country wants to
maintain the exchange rate of a local currency undervalued, it has
to buy ……………………………………………… paying with
…………………………………………… Then, its official reserve assets
……………...
 When economic authority (central bank) of a country wants to
maintain the exchange rate of a local currency overvalued, it has
to buy ……………………………………………… paying with
…………………………………………… Then, its official reserve assets
……………...