In this video we’ll examine floating exchange rates and see how they are determined.
In future videos we will take a look at fixed and managed float systems.
Floating exchange rates are determined by the market forces of supply and demand in
the foreign exchange market.
The value of the currency is determined solely by market forces and not intervention by the
government.
When discussing appreciation or depreciation of currencies, we are generally referring
to floating exchange rate systems.
Appreciation occurs when a currency gains in value relative to other currencies.
Depreciation occurs when a currency loses value relative to other currencies.
Why appreciation and depreciation occur, we’ll see in the remainder of this presentation.
Let’s start with our supply and demand diagram from unit 2, but we’ll make some slight
adjustments for foreign exchange, considering the market for US dollars being purchased
by people or institutions from the UK.
From unit 2 we can recall that market forces determine an equilibrium price and equilibrium
quantity for a good.
Next we’ll see how this applies to the market for dollars.
We change the Y-axis label from price to ‘Exchange Rate’ because the exchange rate represents
the price of dollars in pounds.
We change quantity to quantity of dollars to clarify the currency market we are discussing.
Finally, we change equilibrium price, P* to ER* to reflect the equilibrium exchange rate.
If you’re drawing a diagram for exchange rates, I highly encourage you to use this
format.
We’ll examine changes in demand - In this example we are simplifying the foreign exchange
market for dollars to two countries, the US and UK.
Since we are discussing the market for dollars, the UK is on the demand side.
UK parties represent the groups interested in purchasing dollars.
Factors that affect the demand for a currency can also influence its supply.
We’ll discuss that later.
Right now, we will focus on the reasons that demand for a currency increases.
For the sake of discussion, we’ll continue with our British pound and US dollar analysis.
The demand for currency is derived partially from the demand for a country’s goods and
services.
If there is an increase in the attractiveness of American goods to British consumers, then
the demand for the dollar will increase.
This could be due to a host of factors including relative price levels, improved quality and
changes in tastes and preferences.
All other things being held constant, a decrease in the US rate of inflation will make American
products more price competitive and should drive up their demand.
This could in turn drive up the demand for dollars, causing an appreciation of the dollar.
This can also work the other way, with a rise in the price level of the US reducing the
demand for goods and services by British buyers and thus cause the dollar to depreciate.
If interest rates are relatively higher than they are in other countries, this could attract
money flows into the US as foreign investors seek the more attractive returns offered by
American banks.
These are called hot money flows and tend to increase into a country with rising interest
rates.
Deposits in American banks are predominantly made in dollars and British depositors will
have to change their pounds to dollars in order to deposit them in the US.
In general you can say that interest rates have a direct relationship with exchange rates;
exchange rates tend to follow movements in the interest rate.
Finally, speculation can result in an increase or decrease in the demand for a currency.
For example, the Chinese government devalued the Chinese RMB in the past two years and
this has led some Chinese citizens to purchase and hold US dollars.
They view the dollar as more stable and possibly seek to benefit from what they perceive as
a long-term opportunity of holding dollars in order to buy RMB back at a favourable rate
in the future.
If the Olympics are being hosted in the United States, the increase in tourists from the
UK to the US will increase the demand for US dollars as British tourists exchange their
pounds for dollars in order to purchase more American goods and services during their travels
to the US.
This will shift the demand for dollars to the right, causing the American currency to
appreciate.
It will also cause an increase in the equilibrium quantity of US dollars in the foreign exchange
market.
Suppose now that there is a decrease in interest rates offered by American financial institutions
for depositors.
This will reduce the demand of US dollars by British investors as the United States
is now less attractive to invest in relative to other countries, or even the UK itself.
This reduction in the demand for the dollar causes it to depreciate and the equilibrium
quantity exchanged to decrease.
Next we will examine changes in supply - once again we will continue with our UK and US
example.
Since we are discussing the market for dollars, the US is on the supply side as obviously
dollars originate from the US.
Essentially all the factors that influence the demand for the dollar affect the supply
of the dollar as well.
To understand why this is you have to remember that the demand for the dollar is met by supplying
the pound.
Therefore, if Americans increase their demand for the pound they must supply dollars in
exchange.
The same factors we listed earlier can be used to apply to Americans supplying the dollar
on the foreign exchange market too.
If Americans demand British goods and services, they need pounds.
Additionally, if the UK price level falls relative to the US, British goods will be
more price competitive.
If it’s more rewarding to save money in the UK, then Americans will increase their
deposits at UK financial institutions.
Finally, if Americans believe the UK pound is currently undervalued and will rise in
value in the future, they may choose to buy it today in order to benefit from its rise
in the future.
In this example, Americans are either increasing or decreasing their supply of dollars in the
foreign exchange market.
Imagine there is a sudden increase in the demand for British goods and services by Americans.
Americans will increase the supply of dollars on the foreign exchange market in order to
buy pounds and the dollar will depreciate against the pound.
This will also cause an increase in the equilibrium quantity of dollars in the foreign exchange
market.
Now suppose the demand for UK imports in the US decreases, perhaps due to a boycott of
UK products.
If that were the case, there would be a fall in demand for UK pounds in the market for
pounds and there would be a decrease in the supply of dollars in the market for dollars.
This would result in an appreciation of the dollar as it would now take more pounds to
buy one US dollar.
It would reduce the equilibrium quantity of dollars in the forex market as well.
Thanks for watching this video on floating exchange rates.
As always I hope you have found it helpful.
If you have any questions, you can leave them below or email me at enhancetuition@gmail.com.
You can also tweet me @enhancetuition.
As always, happy studying and I will see you in the next one.