Determination of Foreign

Exchange Rates

By Dr (Prof) Sandeep Parmar

 Determining exchange rates
A flexible or floating exchange rate is where the
market forces of supply and demand determine the
exchange rate.
 A fixed exchange rate is where the government
determines the exchange rate for a period of time
based on the value of another country’s currency
such as the US dollar.
 A managed exchange rate is where the government
intervenes in the market to influence the exchange
rate or set the rate for short periods such as a day or
week.
 Fixed exchange rates
 The World Bank and the IMF were both established
in 1944 at a conference of world leaders in Bretton
Woods, New Hampshire (USA). The aim of the two
"Bretton Woods institutions" as they are sometimes
called, was to place the global economy on a sound
footing after World War II. To help reduce the
economic instability that existed the conference
favoured the use of a fixed exchange rate system.
 Under a fixed exchange rate system the value of a
country’s currency is fixed by the government or
one of its agencies, for example the Reserve Bank
of Australia (RBA) to another currency for a specific
time period.
A fixed exchange rate system does not imply
that the rate will stay at that same level all the
time. The government may decide to change
the rate because of adverse effects on the
economy. For example, if the currency is
overvalued exporting industries will become
less internationally competitive, affecting
international trade and the balance of
payments and the government might take
action to devalue the exchange rate
A devaluation of a currency occurs under a
fixed exchange rate system when there
isdeliberate action taken by a government to
decrease its value in the forex market.
 Alternatively a revaluation occurs under a
fixed exchange rate system when there
isdeliberate action taken by the government
to increase the value of the currency in the
forex market.
Flexible exchange rate
system
 The value of a nation’s currency, under a
floating exchange rate, is determined by the
interaction of supply and demand
The laws of supply and
demand show that:
Prices of goods, commodities and
exchange rates are determined on
open markets under the control of two
forces, supply and demand.
1. High supply causes low prices, and high demand
causes high prices.
2. When there is an abundant supply of a given
commodity then the price should fall.
3. When there is a scarce supply of a given
commodity then the price should increase.
4. Therefore, an increase in the demand for a
commodity would cause it to appreciate in value,
whereas an increase in supply would cause it to
depreciate.
Exchange Rate Equilibrium
 Forces of Demand and Supply
 Demand for foreign currency negatively
related to the price of foreign currency
 Supply of foreign currency positively related to
the price of foreign currency
 Forces of demand and supply together
determine the exchange rate
Relationship between exchange rate
and demand for foreign exchange
 Inverse relationship
 It means when exchange rate increases then
demand for foreign exchange decreases
and vice versa
A) When exchange rate
increases
 When exchange rate increases, the imports
become costlier and importers curtails the
demand for imports. Consequently, the dd for
foreign currency falls.
B) When exchange rate
decreases
 Whenexchange rate decreases, the imports
become cheaperand importers increases the
demand for imports. Consequently, the
demand for foreign currency increases.
Flexible (or floating)
exchange rates
 Under a flexible or floating exchange rate the
value of a country’s currency changes
frequently, even by the minute. The market
rate will depend on the demand for, and
supply of, that currency in the forex markets.
When there is no intervention in the free
market operations by a government agency
a “clean float” is said to exist.
 The demand curve (DD) indicates the quantity of
Australian dollars that buyers (those people who hold
US dollars) are willing to purchase at each possible
exchange rate.
 The supply curve (SS) shows the quantity of
Australian dollars that will be offered for sale (those
people who hold Australian dollars) at each exchange
rate.
 At the equilibrium exchange rate of $A1.00 =
$US0.50 the equilibrium quantity supplied and
demanded is Q1 Australian dollars. At an
exchange rate above equilibrium, such as
$A1.00 = $US0.60, an excess supply of
Australian dollars exists and market forces will
force the exchange rate down towards
equilibrium.
 If the exchange rate is below equilibrium,
such as $A1.00 = $US0.40, an excess
demand situation exits and market forces will
put upward pressure on the value of the
Australian dollar.
A currency appreciation
 In Figure 2a there has been an increase in
demand (DD to D1D1) for Australian dollars.
This has led to an increase (appreciation) in
value of the Australian dollar from $US0.50 to
$US0.60 and the quantity of Australian dollars
traded has also increased from 0Q to 0Q1.
 The shift in the demand curve could have
been caused by an increase in the demand
for Australian exports, such as coal,
aluminum, beef or lamb
 InFigure 2b there has been a decrease in the
supply (SS to S1S1) of Australian dollars. This
has led to an increase in the value
(appreciation) of the Australian dollar from
$US0.50 to $US0.60. However the quantity of
Australian dollars traded has decreased from
0Q to 0Q1.
 This decrease in the supply of Australian
dollars may have been caused by a
recession, slowing the demand for imports.
A currency depreciation
 In Figure 3a there has been a decrease in
demand (DD to D1D1) for Australian dollars.
This has led to a depreciation in the value
of the Australian dollar from $US0.50 to
$US0.40. The quantity of Australian dollars
traded has also decreased from 0Q to 0Q1.
 The decrease in the price of Australian dollars
in terms of US dollars could have been
generated by a slow down in global economic
activity, so decreasing the demand for
Australian exports, or because of foreign
investors lacking confidence in the Australian
economy and investing elsewhere.
 Figure 3b indicates an increase in supply of
Australian dollars with the supply curve
moving from SS to S1S1. Again the value of
the Australian dollar has decreased from
$US0.50 to $US0.40 while the quantity of
Australian dollars traded has increased from
0Q to 0Q1.
 The depreciation may have resulted from
strong domestic economic growth increasing
the demand for imports, or from higher
overseas interest rates, causing a capital
outflow from Australia.
Managed exchange rates

A managed exchange rate occurs when there

is official intervention by a government or an
agency such as the RBA to determination the
value of a country’s exchange rate. Through
such official interventions it is possible to
manage both fixed and floating exchange
rates.
 The Australia dollar was pegged to TWI from
September 1974 to November 1976. Then
in November 1976, the government adopted
a “managed flexible peg” or a “crawling
peg system”. Under this new method of
determining exchange rates, the value of the
Australian dollar was changed relative to
the TWI, not just relative to a single
individual currency