Chapter 9
EXCHANGE RATE
(The price of foreign currency against domestic currency)
1
Exchange Rate
= is simply the number of monetary units of one country’s
currency to that of one unit of another country’s
currency.
= that is the ratio for which one currency to be traded
with another.
2
Types of Foreign Exchange (FOREX)
System:
1. GOLD STANDARD (1920)
2. FLEXIBLE/ FLOATING EXCHANGE
RATE SYSTEM
(no/less government intervention).
3. FIXED EXCHANGE RATE SYSTEM
(with government intervention)
3
CHARACTERISTICS of:
Value of money is
equivalent to the
gold content.
Its monetary units
is in terms of the
gold price.
Exchange rates
can fluctuate
between gold
points (par value)
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Freedom of selling
and buying / export
and import of gold
1. GOLD
STANDARD
The rate of
exchange: depend
on the ratio of
gold content
Disadvantages of
Gold Standard:
 A cumbersome (rare and difficult) system.
 are idle resources which are a wastage.
 Countries did not follow the rules strictly as their
economy gets disrupted.
 Countries tend to devalue their currencies in times of
deficit BOP.
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2. FLEXIBLE / FLOATING EXCHANGE
RATE SYSTEM:
– is when the government does not intervene in the
foreign exchange markets, but simply allows the
exchange rate to be freely determined by demand and
supply in the market.
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I.
Free Floating Exchange Rate System
(no government intervention)
II.
Managed Floating System (1971– 1998) and from 2005 until
now.
(less government intervention)
Determination of Exchange Rate through
the market.
Exchange Rate
(RM)
(price of RM forUS$1)
SS
4.00
2.00
DD0
DD1
Q1 Q0 Quantity of Ringgits
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The Exchange Rate is determined by the
Market Forces of Demand and Supply of
Ringgits.
DEMAND FOR FOREIGN
CURRENCY:
 is a “derived demand” that is related to the debit
items in the Balance of Payment account.
 For example, Demand for foreign currency
increases when:
 import of goods and services increases.
 investment in foreign country increases.
 transfer of payments to residents in that
foreign country increases.
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Factors that may affect the
Demand for Ringgit :
 relative price level of goods – cheaper price will have
higher demand on goods larger exports and
therefore higher demand for that currency.
 high income and wealth.
 rate of exchange of a currency.
 high foreign investment – demand for ringgit rises.
 expectation of future exchange rate – speculation
purposes.
 government expenditure overseas.
 political stability
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SUPPLY OF FOREIGN CURRENCY:
 is derived from the credit items in the Balance of
Payment account.
 For example:
- export of Malaysian goods and services.
- foreign investment in our country.
- transfer of payments into our country.
10
Ringgit Depreciation
from the diagram:
 The ringgit has fallen in value from US$1: RM4.00 to
US$1: RM2.00 – ringgit has depreciated in value,
- after a fall in demand for ringgit (especially
when less goods are exported).
When DD < SS => Exchange Rate will fall
(depreciated)
 and if DD > SS => Exchange Rate will rise
(appreciated)
 BNM will monitor the exchange rate against currency
basket to ensure that the exchange rate remains close to
its fair value.

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Major foreign exchange rates
(at average buying and selling rates)
4th.Feb. 2005
4th.Sept. 2007
Australia$1
RM2.90
RM2.85
British£1
(sterling pound)
Euro 1
RM7.15
RM7.1
RM4.90
RM4.75
¥ 100
RM3.64
RM3.02
US$1
RM3.80
RM3.51
(During pegged system) (After pegged system)
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Advantages of
Flexible Exchange Rate System:
 Exchange rate is determined by FOREX market
therefore does not require to keep foreign
exchange reserves.
 No or less government intervention, therefore less
work in monitoring and implementing controls.
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Disadvantages of
Flexible Exchange Rate System:
 Problems of instability of Exchange Rate – affects to the
instability of the
economy.
 Developing countries will always under
values.
 Foreign long-term investment will fall –
FOREX.
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depreciating
instability of
3. FIXED EXCHANGE RATE SYSTEM
- BRETTON WOOD SYSTEM (1934)
(Pegged Exchange Rate System)
 is managed by the national monetary authorities –
Bank Negara (meaning that with the intervention of
the government.)
 The rate of exchange between currencies was pegged
within specified narrow limits.
 In Malaysia, the Ringgit was pegged to US$1 for
RM3.80 from Sept. 2, 1998 and allowed to operate in a
managed float on July 21, 2005.
 Reason : to reduce the volatility of the RM exchange
rate and to promote a stable environment conducive
to economic recovery.
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Exchange Rate was pegged within
narrow limits
RM
SS
3.85
Upper limit
3.80
3.75
Lower limit
DD
Quantity of Ringgits
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To stabilize the
FOREX market:
 Government can support the market to stabilize the Exchange Rate
from depreciating or appreciating
– to keep the exchange rate stable: through the buying or selling of
foreign currency.
 Any excess supply of ringgits need to be bought by the Government
using its reserves of foreign currency.
On the other hand, government needs to sell foreign reserves to
support the price of ringgit – under shortages.
 A country may have done DEVALUATION to solve the deficit in the
Balance of Payment, that is to devalue her currency and makes her goods
becomes cheaper compared to others in terms of domestic currency
(ringgit).
 Instead, an APPRECIATION (REVALUATION) of ringgit
might solve the Surplus in the BOP.
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ADVANTAGES OF
FIXED EXCHANGE RATE SYSTEM:
* No speculative activities – minimum
uncertainties.
* Low risk in exchange rate fluctuation –
not necessary for hedging.
* A country is insulated from external
financial instability.
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DISADVANTAGES OF
FIXED EXCHANGE RATE SYSTEM:
 Central bank need to have sufficient foreign exchange
reserves to stabilize the Ringgit.
 under Flexible Exchange Rate System, foreign exchange
reserves is not necessary.
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GOLD DINAR
to be adopted as a substitute currency for international
trade – as it is more stable and less prone to speculative
activities.
Being a neutral currency, is also an ideal instrument to
facilitate trade among Islamic countries.
Gold Dinar is used to settle:
 bilateral trade payment
- Bilateral Payment Arrangement (BPA)
 multiple trade payment
- Multiple Payment Arrangement (MPA)
20
Transfer of beneficial ownership
 Gold Dinar will not exist in physical transfer but only of
beneficial ownership in respective accounts and may be
settled in every 3 months or so.
 The payment will be assigned a value of gold:
21
For example:
1 gold dinar ≡ 1 ounce of gold
The price of 1 ounce of gold = US$290
and US#1 = RM3.80 .
Therefore, 1 gold dinar = US$290
= RM (290 X 3.80)
= RM1102.
EXCHANGE RATE FROM ISLAMIC
PERSPECTIVE (As-Sarf)
 To facilitate international trading Islam permits the
trading of different currencies.
 To avoid the involvement of riba, transaction must be
of the same commodities and was taken place at the
spot).
 2 types of riba involves here, either riba Al-Fadhlu
(because of different commodities traded) or riba
An-Nasiah (because of the place of transactions does
not take place on the spot). So transactions of money
represent commodities being traded at the same
time.
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