CHAPTER 14 .

I
FREELY FLOATING EXCHANGE RATES
INTRODUCING EXCHANGE RATES

Demand and supply of foreign exchange

o) At any moment in time , there's a continuous flow of money in-1 Out of every country in the world

-
this happens to the residents of each country , whether indivslgronps of indi vs l firms I the govt have transactions ( dealings Of
,
any kind

involving money ) w/ the residents of Other countries

07 International transactions involve the use of different national currencies , known as foreign exchange
-
these national currencies are traded for each other in the foreign exchange market , where ihdivs , firms , banks , other financial

institutions, -19 outs buy -1 sell currencies

-
the foreign exchange market is not a centralized meeting place , but involves any location where one currency can be exchanged for

another, t any in dirt organization that engages in the RX change of one currency for another

o) suppose you're a resident of Russia traveling to Denmark

you will want to exchange some of your roubles for Danish kroner
-

'
to do this , you yell your roubles buy Danish kroner in the forex market
' '
-
t

→ Do residents of any country usually prefer to be paid in the currency of that country

-
likewise , residents of eurozone countries want to be paid in euros, residents of Chile want to be paid in Chilean pesos , t residents of Malaysia

want to receive payments in ringgits

01 The forex market , like any market, is made up of demand t supply of Gurren oils

-
as a traveller from Russia , when you Change your roubles into Danish kroner , you demand Danish kroner +
you supply roubles in the forex

market

o) suppose residents in the UK t Japan want to trade w/ each other

-
when Japanese residents import from the UH , they must buy British pounds w/ which to pay UK exporters ; they therefore demand British

pounds in the forex market

-
to receive the pounds they sell I supply yen in the forex market
,

-
when UK residents import from Japan , they demand yen . + supply pounds in the forex market to receive the yen

-
this simple 2 -
country example illustrates the equivalence between the demand for
-

a foreign currency t the supply of a domestic currency

→ the demand for pounds = supply of yen ; demand for yen supply of pounds
-
-

→
there is a similar equivalence in the real world , where there 're many different currencies : the demand for yen is equivalent to the

supplies of all other currencies offered bold in the forex market to buy yen

↳ similarly , the demand for pounds is equivalent to the supply of all other currencies offered to buy pounds

o) The demand for foreign currencies generates a supply of domestic currency ; t demand for the domestic currency generates a supply of

foreign currencies

o) In a simple 2- currency example using pounds -1 yen it follows that : ,

-
demand for pounds supply -
- of yen

-
demand for yen Supply of pounds

Exchange rates

national currencies exchanged from each other , there must be some mechanism of establishing the ' value of each currency
'
01 If can be

-
this is done through the exchange rate which relates the value of one currency to another
,

O) consider a hypothetical exchange rate between the US dollar t the euro :

-
# Of US dollars per euro ! 1.5 dollars = I euro

-
# Of euros per dollar 0.67 euro 1 dollar
: :

→ the 1st expression gives the ' vamp '

l '
Price Of
'
a euro in terms of dollars Showing how many dollars can be obtained if a euro is given
.

up

the 2nd gives the value l ' price ' of a dollar in terms of euros , showing how many euros must be given up to buy a dollar
→ ' '

→
the 2 expressions are equivalent since the value of each currency is expressed
,
in terms of the other

'
o) 2 ' pure exchange rate systems :

① the floating ' flexible exchange rate system

② The fixed exchange rate system

 01 Actual system used today : managed float I managed exchange rate system

-
lies in between the 2 '
pure systems though it's closer
'
, to the system of floating exchange rates

DETERMINATION OF FREELY FLOATING EXCHANGE RATES

The equilibrium exchange rate

o ) in a freely floating exchange rate system Iflexible exchange rate system exchange rates , are determined by market forces Ahe forces of

demand -1 Supply

-
there's no govt intervention in the forex market to influence the value of currencies

o ) consider a highly simplified world w/ 2 Currencies : USD t euro

in a freely floating system , the ' price Of the dollar the ' price ' of the euro are each determined in the same way that prices are
'
-
t

determined in any free market

expressed
'
-
however, the price of a currency is always
'
in terms of another currency , as there's no independent unit we can use to express

the value of currencies

in a market for computers loarslshoesl any good , service , resource price is measured in terms of units of money , which serves as a unit
-

→ ,

of measurement of Value

→ in the base of currencies , there's no independent unit to measure value ; therefore , value is measured in terms of another currency

01 Fig 14 I lat : market for USD

.

la ) The market for US dollars -

horizontal axis measures the quantity of dollars

€ per D= -
vertical axis measures the price of dollars in terms of euros
S Ot $
price of 15 in excess supply of $
terms of € ( dollars ) demand for dollars comes from eurozone residents who need dollars to
#
-

0.80 - - - - - - - - - - -

carry out transactions in the US : eurozone importers buying goods from the
0.67 ← equilibrium
US , eurozone investors who want to invest in the US , consumers going on
- - - - - - - - -

exchange rate

0.50 - - - - - - - - - - - - holiday to the Us , etc .

-
excess demand for $
→ downward slope : as the price of dollars in terms of euros increases , euro
D for $
( dollars ) zone residents buy fewer dollars
0
Q of $1 dollars I ex : if 0.80 euro are needed buy 7 dollar, eurozone residents buy fewer
'
→ to

(b) The market for euros dollars than it 0.5 euro is needed to buy 7 dollar

IS Ppr E- -
supply of dollars comes from us residents who would like to give UP dollars
5 of E
price off in excess supply of E
HMOS )
terms of $ # to buy euros : US residents who would like to import goods from euro tone
2. 00 - - - - - - - - - - -

countries , or who want to take a holiday in a eurozone country , or who plan

1. 50 ← equilibrium
to invest in eurozone country etc
- - - - - - - - -

a
exchange rate , .

1.25 - - - - - - - - - - - -
→
why it's upward sloping : consider that if the price of dollars is 0.5 euros
-
excess demand for E per dollar US residents need
, to supply 1 dollar to buy 0.5 euro worth of
D for E
( euros ) eurozone goods
O
Q of Fleurus ) ↳ if the price of dollars increases to 0.8 euro per dollar then by giving
,

Figure 14.1 Exchange rate determination in a freely floating

up 1 dollar, US residents can buy 0.8 euro worth Of euro tone goods
exchange rate system
→
as the price of dollars in terms of euros increases , the quantity of dollars supplied increases
-
the intersection of demand + supply curves determines the equilibrium ' price of the dollar in terms of the euro '

price is the equilibrium exchange rate which is 0.67 euro per dollar
' '
→ this ,

→ if the exchange rate were higher , say at 0.8 per dollar there would be
, an excess supply of dollars

→
at any lower exchange rate such as 0.5 , euro per dollar there would be
, an excess demand for dollars

0) in a freely floating exchange rate system , the forces of demand 4 Supply cause the exchange rate to settle at the point where the quantity

of a currency demanded equals quantity supplied

-
this is the equilibrium exchange rate

01 Fig 14.1lb ) market for euros

. :

-
since the demand for dollars is equal to the supply of euros , t the supply of dollars is equal to the demand for euros , it follows that

when we determine the '

price ' Of dollars , we also determine the ' price ' Of euros

-
demand curve , showing demand for euros by US residents who want to buy euros to import , travel invest , etc
, . in eurozone countries is ,
a

reflection of the supply of dollars in la )

- -

supply curve showing , the supply of euros from eurozone residents who want to buy dollars to import travel , invest , etc
, . in the US , is a

reflection of the demand for dollars in Id ) - -

 the intersection of the demand for euros 1- euros curves determines the equilibrium exchange rate I the ' price of the euro in
'
supply of
-
- - -
-

terms of the dollar , which is 1 euro 1.5 dollars

-
-

→
at any higher price of the euro there would be an excess supply of euros

→
at any lower price there would be an excess demand for euros

01 The 2 equilibrium exchange rates in fig 14 I are .

.
equivalent to each other

-
at any other exchange rate , the markets are in disequilibrium

→ when the price of dollars in terms of euros is 0.80, there's an excess supply of dollars that corresponds to an excess demand for euros

→ when the price of dollars in terms of euros is O 50 , the excess demand for dollars reflects
-
an excess supply of euros

01 Once an exchange rate settles at its equilibrium value , it'll remain there until there's a change in demand I supply of the currency , expressed as

a shift in the currency demand Is up ply curve

EXCHANGE RATE CHANGES : APPRECIATION 1- DEPRECIATION

01 The value Of the dollar increases if there's ( Fig 14 .
-
21 :

lol an increase in the demand for dollars , causing the demand for dollars curve to shift to the right - -

(b) a decrease in the supply of dollars causing the supply Of dollars curve to shift to the left
,
- -

o) An increase in the value of a currency in a floating exchange rate system is called an appreciation of the currency

(a) Demand for $ increases :$ appreciates lb ) supply of E increases : E depreciates

€ Per $ = Is per =

price of $ in S of $ Price off in S , off

terms of E terms of $

0.90 -0 C 52 Off
- - - - - - - - - - - -

D
A B
0.67 - - - - - - - - -
co - - - - - -
to
1.50 - - - - - -
to - - - - - -
o
e
D2 for $
F
1. 11 - - - - - - - - - -
to

D , for $

D for E
o o
Q of $1 dollars ) Q of fleur 051

Figure 14.2 Exchange rate changes in a freely floating exchange rate system
O) The value of the dollar decreases if there's :

⑦ a decrease in the demand for dollars causing , a leftward shift in the demand for - -
dollars curve

② an increase in the supply of dollars, causing a rightward shift in the supply Of dollars curve - -

01 A fall in the value of a currency in a floating exchange rate system is called a depreciation of the currency

01 In fig 14.2 , assume that the market for dollars t

.
euros is initially in equilibrium ; suppose that be of a change in consumer tastes eurozone ,

countries want to import more goods from the US

-
this leads to an increase in the demand for dollars , t an increase in the supply of euros that 're given up to buy the dollars

01 Fig .
14.2 lol )

-
demand for dollars shifts
- -
to the right from , D , to Dz , leading to a new , higher equilibrium exchange rate of 0.90 euro = 1 dollar
-
the price of the dollar in terms of euros has increased ,
t the dollar has appreciated , or increased in value relative to the euro

o) Fig 14.2lb )
.

-
at the same time, the increase in the supply of euros appears as a shift to the right in the supply of euros curve , from S , to Sz , resulting in
- -
a

new , lower equilibrium exchange rate of 1.11 dollar -4 euro

-
the price of the euro in terms of the dollar has fallen , so the euro has depreciated Idecreased in value relative to the dollar

-
the new exchange rates of 1 dollar : 0.90 euro , 41 euro it 11 dollar are .
equal :

I dollar 1.11 dollar

- = -

0.90 euro I euro

-
an appreciation of One currency involves a depreciation of the other currency

-
if the US had wanted to import more from eurozone countries , the result would be the opposite

o) The same general principles apply to the international system consisting of many national currencies

when a currency appreciates it does so against all others in a floating exchange rate system , meaning that all others appreciate relative
-
-

to it

-
when a currency depreciates , all other currencies appreciate relative to it
 01 In a floating exchange rate system appreciation ( increase , in value ) t depreciation ( decrease in value) of a currency occur as a result of

changes in demands supply for a currency

TEST YOUR UNDERSTANDING 14 -

l

expressed
'
l .
The '
price of a currency is always in terms of another currency , as there's no independent unit we can use to express the value of

currencies

2 . In a freely floating exchange rate system , the forces of demand and supply that cause the exchange rate to settle at the point where the

quantity of a currency demanded equals quantity supplied determine the equilibrium exchange rate

3 . la ) supply of USD

(b) Demand for USD

10 ) supply of USD

(d) Supply Of USD

4 .
An increase in the value of a currency in a floating exchange rate system is called an appreciation of the currency , while a fall in the value

of a currency in a floating exchange rate system is called a depreciation of the currency .

la ) E PPV $ lb) $ Pdr f- USD will depreciate

=
5 .
=
lo )
price of $ in price of Ein s off
g, of $
terms of € terms of $ relative to euros ,

Sz of $ Pz - - - - - - - - - - - - -
a o euros will appreciate

Pi - - - - - -
to p, - - - - - - - - -
a relative to USD

Dz for €
Pz - - - - - - - - - -
to

D , for €

D for $
o o
Q of 151USD ) Q of €1 euros )

The supply of USD increases due to the increase the demand for euros increases due to the increase

in the demand for euros -

causing supply to in US importers buying goods from eurozone countries

shift rightwards from S , to Sa This causes the .

-
causing demand to shift to the right from D , to Dz .

value of USD to depreciate from P , to Pz This leads to an appreciation of the value of the euro

relative to euros from Pi to Pr relative to USD .

CAUSES OF CHANGES IN EXCHANGE RESULTS

01 In the real world , there 're numerous ongoing changes in demand t supply of currencies causing exchange rates of most currencies
,

around the world to fluctuate on a daily I even hourly basis

Foreign demand for a country 's exports

o) changes in foreign demand for a country 's exports affect its exchange rate

01 If there's an increase in foreigners '

demand for Swiss watches the demand for Swiss francs increases , the demand for francs curve shifts
.
-
-

to the right + the franc appreciates

01 A decrease in the foreign demand for a country 's exports causes its currency to
-

depreciate
01 As demand for a country 's exports increases its currency appreciates, oeteris Paribas
,

Domestic demand for imports

01 Changes in a country 's demand for imports affect its exchange rate

o) If consumers in the US import more foreign made cars US importers must buy foreign currencies , t -
, to do so they supply I sell ) USD in the

forex market

-
as the supply of USD increases , the supply of USD curve shifts to the right , -1USD depreciates
-
-

01 If the US demand for foreign cars falls , there's a leftward shift in the supply of USD curve , t USD appreciates
- -

01 As a country 's imports increase its currency appreciates cater is pari bus
, ,

Relative interest rate change

01 Financial capital : funds that 're used to make financial investments , investments that receive a return based partly on the rate of interest

01 The higher the rate of interest in a country , the more attractive the financial investments in that country

-
ex : if the interest rate in UK increase relative to interest rates in other countries, financial investments become more attractive in UK ,

financial capital flows to UK , demand for British pounds increases the demand for ,
- -
pounds curve shifts to the right -1 the pound

appreciates
-
similarly , if interest rates in UK fall relative to interest rates in other countries financial ,
capital flows out of UK , the supply of pounds

increases ( as investors demand other currencies) , the supply of pounds curve shifts to the right , t the pound depreciates - -