Exchange Rates
International Trade & Globalisation
A floating exchange rate is determined by market forces: the demand for and the supply of the currency on the foreign exchange market. The government does not target a particular rate.
How the rate is set:
- Demand for the currency comes from foreigners who want to buy this country's exports, invest in it, or send money into it. To do any of these they must first buy the currency.
- Supply of the currency comes from domestic residents who want foreign currency, to pay for imports, to invest abroad, or to travel.
- The equilibrium exchange rate is the rate at which the demand for the currency equals the supply of it. If demand rises above supply, the rate is bid up; if supply exceeds demand, the rate falls, until the two are equal again.
Common exam question
Which change shifts a currency's demand or supply
Question: Pick the change that would shift the demand for, or the supply of, a country's currency, often shown on a diagram of its market (1 mark, multiple choice).
Set in 9 of the 13 multiple-choice papers, six times with a diagram. Name the currency being traded and ask who must buy or sell it. Demand rises when foreigners buy more of the country's exports (services count), invest more there or chase a higher interest rate; supply rises when its own residents buy more imports or invest abroad. So more imports shift the supply of the home currency right, lowering its price.
Wrong options reverse the cause or move the other curve. Check whose interest rate changed: lower US rates cut the demand for US dollars, while lower Chinese rates raise it. Cheaper oil cuts the demand for dollars too, because oil is paid for in dollars and its demand is price inelastic, so spending on it falls.
An appreciation is a rise in the value of a floating currency caused by market forces. A depreciation is a fall in its value caused by market forces.
Examples of floating currencies include the US dollar, the UK pound, the euro and the Japanese yen.