Exchange rate refers to price of one currency in terms of another currency.
Exchange rate system
This refers to methods of determining exchange rate. There are two methods of determining exchange
arte.
1. Floating exchange rate – determining the price of one currency in terms of another currency,
through market forces.
Demand for currency comes from foreigners to purchase domestic goods, services or to save in the
country.
Supply of currency comes from the domestic citizens to buy goods and services from abroad or to save
abroad.
The intersection of the demand and supply curves gives the exchange rate.
As per the diagram above, the exchange rate determined through demand and supply is --------------------Changes in the market forces will change the exchange rate
Appreciation – refers to an increase in the price of one currency in terms of another currency due to
changes in market forces.
A currency can appreciate either due to an increase in demand for currency or a decrease in supply of
currency.
Demand for currency can increase due to the following reasons;
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Foreigners demanding for goods due to prices being relatively low.
Foreigners demanding for goods due to better quality.
High interest rates results in hot money flowing into the country.
Speculative demand for money.
Supply of currency may reduce due to the following reasons;
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A country adopts protectionism measures and as a result imports reduce.
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Domestic inflation rate lower than trading partners.
Domestic interest rates higher than interest rates in other countries.
Depreciation – a fall in the price of one currency in terms of another currency due to changes in market
forces.
A currency can depreciate due to fall in demand for currency or rise in supply of currency.
Demand for currency may fall due to the following reasons;
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Domestic goods being expensive due to relatively high inflation rate.
Country’s interest may be low, therefore less hot money flowing into the country.
Recession in the rest of the world so less purchasing power.
Supply of currency may increase due to the following;
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Hot money flowing out of the country.
High imports due to less protectionism measures.
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Advantages of floating exchange rate
1. Government is free to achieve other objectives, such as economic growth, price stability. They
do not have to maintain a fixed value for its currency.
2. Government does not have to maintain large foreign reserves. Foreign reserves are stock of
internationally recognized currencies.
3. If there is a current account deficit, it will automatically reduce without government
intervention. This is because when there is a deficit currency depreciates making imports
expensive and exports cheap, this reduce imports and increase exports.
However this happens only if exports and imports have elastic demand.
Disadvantages of a floating exchange rate
1. As currency fluctuates it makes it difficult for firms to plan. E.g. if a firm is importing raw
material may find it difficult to identify import expenses.
2. Uncertainty about exchange rate may discourage trade.
3. When a currency depreciates it may cause inflation. Depreciation makes imports expensive.
Therefore essential raw materials imported will become expensive, making cost of production to
increase. This results in cost-push inflation.
2. Fixed exchange rate – this is when price of one currency in terms of another currency is fixed at
a particular level by the government. Foreign reserves are used to maintain the value.
The exchange rate is fixed at ‘P’, but due to high demand for currency, price has increased. Government
will intervene and push the value down to the agreed level by selling its own currency and buying
foreign currency. This will increase foreign reserves.
If the value reduce due to high imports government will push the price to the agreed level by buying its
own currency and selling foreign currency. This reduce foreign reserves.
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Advantages
1. It creates certainty. Firms that buy and sell goods abroad will exactly know the amount to pay or
receive.
Disadvantages
1. Government will have to maintain large amounts of foreign reserves, to keep the exchange rate
fixed at a particular level.
2. Government will have to implement policies which may conflict with other objectives. E.g.
central bank may increase interest rate to prevent value of currency from falling. However high
interest rates may discourage consumption and investment reduce output and slow down
economic growth.
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