Unit 7: Foreign Exchange/ Flexible & Fixed Rates

Foreign Exchange

• Ex: In order to purchase souvenirs in France, it is first necessary for Americans to sell (Supply) their dollars and buy Euros. 
• Any transactions that occurs in the balance of payments necessitates foreign exchange.
• Exchange Rate is determined in the foreign currency markets.

Changes in the Exchange Rates

• Exchange Rates are a function of the supply and demand for currency
• An increase in the supply of a currency will decrease the exchange rate of a currency.
• A decrease in supply of a currency will increase the exchange rate of a currency
• An increase in demand for a currency will increase the exchange rate of a currency
• A decrease in demand for a currency will decrease the exchange rate of a currency

Appreciation and Depreciation

• Appreciation of a currency occurs when the exchange rate of the currency increases
• Depreciation of a currency occurs when the exchange rate of that currency decreases 
• The more you supply, the more the value depreciates. The more you demand, the more value appreciates

Exchange Rates Determinants

• Consumer Rates
• Relative Income
• Relative Price Level
• Speculation

Exports and Imports

• Exchange Rate is a determinant of both exports and imports
• Appreciation of the dollar causes American goods to be relatively more expensive and foreign goods to be relatively cheaper, thus reducing exports and increasing imports
• Depreciation of the dollar causes American goods to be relatively cheaper and foreign goods to be relatively more expensive, thus increasing exports and reducing imports

As two currencies trade: 

• One supply line will change while the other demand line will also change
• They will move in the same direction
• One currency will appreciate while the other will depreciate

Flexible Rates

• Based on supply and demand of that currency versus the other currency
• Very sensitive to the business cycle and it provides options for investment

Fixed Rates

• Based on countries willingness to distribute currency and to control the amount