Exchange rates

What an exchange rate is

An exchange rate is the price of one currency in terms of another. In a floating system it is set by the demand for and supply of the currency in the foreign exchange market.

What moves the exchange rate

Demand for a currency comes from:

• foreigners buying the country's exports;
• foreign direct investment into the country;
• savers attracted by higher interest rates;
• speculators expecting the currency to rise.

Supply of a currency comes from residents buying imports, investing abroad or moving savings overseas.

An increase in demand, or a fall in supply, causes an appreciation. The opposite causes a depreciation.

Worked conversion

If 1 Singapore dollar (SGD) buys 0.74 US dollars (USD), then 1 USD buys 1 ÷ 0.74 = 1.35 SGD (to two decimal places).

A product priced at SGD 200 costs an American buyer 200 × 0.74 = USD 148. If the SGD appreciates to 0.80 USD, the same product costs 200 × 0.80 = USD 160, so Singapore's exports become less competitive.

Exchange rate systems

• Floating: set by the market.
• Fixed: set by the government or central bank, which uses its reserves and interest rates to defend the rate.
• Managed: the currency floats, but the central bank intervenes to keep it within a range.

Singapore is a useful real-world example: the Monetary Authority of Singapore manages the Singapore dollar against a basket of currencies, using the exchange rate as its main monetary policy tool.

Effects of exchange rate changes

A depreciation can:

• make exports cheaper and imports dearer, improving the current account over time;
• raise aggregate demand and growth;
• add to inflation through higher import prices.

At HL, consider whether demand for exports and imports is elastic enough for the current account to improve (the Marshall-Lerner condition), and why it may first get worse before it improves (the J-curve).

Common mistakes

• Saying an appreciation makes exports cheaper.
• Drawing the axes wrongly: the price of the currency goes on the vertical axis, the quantity of the currency on the horizontal.
• Ignoring the time lag before trade volumes respond.