Exchange Rates
1 • The exchange rate is the price of one currency in terms of another. It can be quoted in two ways. Example: In London, the USD is quoted
as follows: 1 GBP = 1.6 USD. It could as well be quoted as follows: 1 USD = 0.625 GBP.
• There are two different exchange rate systems: Flexible (floating) exchange rates and fixed exchange rates.
2 Flexible exchange rates are determined by market forces. There are no interventions by the Government. We look at exchange rate USD per
GBP in London.
21 Flexible exchange rate 22 Appreciation 23 Depreciation
Fluctuations during a time period If, for example, there are more UK-exports than If, for example, interest rates are rising in the US
$ per £ before, demand in £ (and hence supply in $) are (but not in the UK), more $ are demanded (and
increased. Thus, the £ is appreciated; it has a more £ supplied). Therefore, the £ is depreci-
higher value in comparison with the $. More $ ated, it has a lower value in comparison with the
are needed to buy 1 £, or to put it differently, $. Money capital will leave the UK to look for
more $ can be exchanged for 1 £. better returns in the US. Less $ are needed to
buy 1 £, or to put it differently, less $ can be ex-
changed for 1 £.
Time
Exchange rate at a certain moment Appreciation of the £ Depreciation of the £
$ per £ $ per £ $ per £
Supply (S) S S1 £
£ S2 £
D2 £
Demand (D)
£ D1 £ D£
Quantity £ Quantity £ Quantity £
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3 There are different possibilities of fixed exchange rates, ranging from a monetary union to managed exchange rates. We assume a country
X with the currency XM (X-Money). The country X has introduced a fixed exchange rate against the $ ($ 1 = 0.5 XM) with narrow margins of
3 % on either side.
31 Fixed exchange rate 32 Revaluation 33 Devaluation
Fluctuations during a time period. If the XM is appreciated, the Government should If the XM is depreciated, the Government should
supply XM (and demand $) to move the ex- demand XM (and supply $) to move the
change rate back to the range between 2.06 exchange rate back to the range between 2.06
$ per XM and 1.94. The same effect could be obtained if and 1.94. The same effect could be obtained if
interest rates in X (but not abroad) would fall. interest rates in X (but not abroad) would rise.
2.06 S1 XM D2 XM
2 Demand XM $ per XM D1 XM
1.94 S2 XM
$ per XM
2.06 2.06
2 2 S XM
1.94 1.94
Time
Quantity XM Quantity XM
Exchange rate at a certain moment If, however, there is a chronic appreciation, If, however, there is a chronic depreciation, the
the exchange rate and the margins should be exchange rate and the margins should be low-
increased. This increase is called revaluation. ered. This decrease is called devaluation.
$ per XM Demand XM Supply XM S XM
$ per XM $ per XM D XM
2.18
2.06 2.12
2 2.06 2.06
1.94 (2) (2) S XM
(1.94) 1.94
D XM 1.82
Quantity XM
Quantity XM Quantity XM
EXCHRATE.DOC Page 2 (of 2) 15th January 2010
