Foreign exchange rates

Welcome to the World of Foreign Exchange!

Have you ever planned a holiday abroad and noticed that the price of the local currency changes every day? Or wondered why a pair of sneakers made in another country suddenly becomes more expensive? That is all down to Foreign Exchange Rates.

In this chapter, we are going to explore how currencies have "prices," why those prices move up and down like a rollercoaster, and how these movements affect everyone from a local shopper to a massive global business. Don't worry if it sounds complex—think of a currency just like any other product you buy in a shop!

1. What is a Foreign Exchange Rate?

The foreign exchange rate is simply the price of one currency in terms of another. It tells you how much of one money you need to "buy" another money.

Example: If the exchange rate is \( \$1 = €0.90 \), it means you need 90 Euro cents to buy one US Dollar.

Two Main Systems

Governments choose how they want their currency's price to be set. There are two main systems you need to know:

1. Floating Exchange Rate: The price is decided by the "market" (demand and supply). No government interference. Most major currencies like the US Dollar or British Pound work this way.
2. Fixed Exchange Rate: The government or Central Bank "pegs" (ties) the value of their currency to another currency (like the Dollar) or to gold. They work hard to keep it at that exact price.

Quick Review:
- Exchange Rate: The "price" of money.
- Floating: Market forces decide.
- Fixed: Government decides.

2. How is the Rate Determined? (The Market at Work)

In a floating system, the exchange rate is determined by Demand and Supply in the foreign exchange market.

Where does Demand come from?

Foreigners "demand" our currency when they want to buy things from our country. This includes:
- Buying our Exports: If a Japanese person wants to buy an American car, they must first buy US Dollars.
- Investing in our Country: If a foreign firm wants to build a factory here, they need our local currency.
- Saving in our Banks: If our interest rates are high, foreigners want to put their money in our banks to earn interest.

Where does Supply come from?

We "supply" our own currency to the market when we want to buy things from other countries. This includes:
- Buying Imports: If we want a phone from abroad, we "sell" our currency to "buy" theirs.
- Investing Abroad: If a local company opens a branch in another country.

Key Takeaway: When Demand for a currency goes UP, its price (exchange rate) goes UP. When the Supply of a currency on the market goes UP, its price goes DOWN.

3. Why do Exchange Rates Fluctuate?

Exchange rates change because the reasons for demand and supply are always shifting. Here are the four big causes:

1. Changes in Demand for Exports and Imports:
If our goods become very popular globally, Demand for our currency rises, and the exchange rate goes up. If we suddenly start buying lots of foreign goods, we Supply more of our currency to the market, and the rate falls.

2. Changes in Interest Rates:
Think of interest rates as a "magnet" for money. If our Central Bank raises interest rates, foreign investors will want to save money in our banks. They must buy our currency to do this, so Demand rises and the exchange rate goes up.

3. Speculation:
This is like "betting" on the future. if currency traders believe our currency will be worth more in the future, they will buy it now. This increase in Demand makes the rate go up today!

4. Entry or Departure of Multinational Companies (MNCs):
If a huge MNC decides to move into a country and build a headquarters, they bring in massive amounts of foreign money to buy the local currency. This increases Demand and pushes the rate up.

Did you know? This is often called "Hot Money"—capital that moves quickly around the world to wherever interest rates are highest!

4. The Consequences of Exchange Rate Changes

When a currency's value changes, we use two special words in a floating system:

- Appreciation: The value of the currency goes UP (it becomes "Stronger").
- Depreciation: The value of the currency goes DOWN (it becomes "Weaker").

The "SPICED" Mnemonic

To remember how a strong currency affects trade, use SPICED:
Strong
Pound (or Currency)
Imports
Cheap
Exports
Dear (Expensive)

What happens when a currency Appreciates?

1. Export Prices: Our goods look more expensive to foreigners. They might buy less from us.
2. Import Prices: Foreign goods look cheaper to us. We might buy more from them.
3. The Result: We might end up selling less and buying more, which can lead to a trade deficit.

The Role of PED (Price Elasticity of Demand)

Don't worry if this seems tricky! Just remember: PED measures how much people care about price changes.

- If our exports are Price Elastic (people are very sensitive to price), then an appreciation will cause a huge drop in sales because our goods became a little more expensive.
- If our exports are Price Inelastic (like essential oil or unique medicine), people will keep buying them even if the exchange rate makes them more expensive.

Summary Table:
- Appreciation: Exports expensive, Imports cheap. (Good for shoppers, bad for exporters).
- Depreciation: Exports cheap, Imports expensive. (Good for exporters, bad for shoppers).

5. Floating vs. Fixed Exchange Rates

Each system has its "pros" and "cons." Here is a breakdown for your exam:

Floating Exchange Rates

Advantages:
- Automatic Correction: If we have a trade deficit, the currency naturally depreciates, making our exports cheaper and "fixing" the problem automatically.
- No need for Reserves: The government doesn't need to keep piles of foreign gold or cash to protect the rate.

Disadvantages:
- Uncertainty: Businesses don't know what the rate will be tomorrow. This makes it scary to sign long-term trade deals.

Fixed Exchange Rates

Advantages:
- Certainty: Firms know exactly what the price is. This encourages international trade and investment because there is no risk of the currency price crashing.
- Inflation Control: It forces the government to be "responsible" with money to keep the rate stable.

Disadvantages:
- Large Reserves Needed: The Central Bank must constantly buy and sell its own currency using foreign reserves to keep the price fixed. This is very expensive!
- Loss of Control: The government cannot use interest rates to help the local economy because they are too busy using them to keep the exchange rate fixed.

Common Mistake to Avoid: Students often think a "Strong" (appreciated) currency is always good for a country. It isn't! While it makes holidays cheaper, it can put local factories out of business because their exports become too expensive for the rest of the world to buy.

Final Key Takeaway:
Exchange rates are the heartbeat of international trade. Whether they move freely (Floating) or are held steady (Fixed), they determine how much we pay for imports and how much we earn from exports.