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Chapter 11

Financial systems 3
foreign exchange
markets

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CHAPTER CONTENTS
LEARNING OUTCOMES ------------------------------------------------- 127
FOREIGN EXCHANGE RATES ------------------------------------------- 128

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FLOATING EXCHANGE RATES

129

FIXED EXCHANGE RATES

133

SINGLE CURRENCY ZONES

133

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LEARNING OUTCOMES
a) Explain the role of the foreign exchange market and the factors influencing
it, in setting exchange rates.

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FOREIGN EXCHANGE RATES


An exchange rate is the rate at which one currency trades for another on the
foreign exchange market.
If US citizens wish to visit the UK, or a US firms wishes to acquire UK goods and the
exchange rate is 1 = $1.50, this means they will have to pay $1.50 to obtain 1
worth of UK goods or assets.
Assets traded in the foreign exchange markets are deposits of the currency itself as
well as bonds denominated in foreign currencies.
The main participants in foreign exchange markets include: banks, investments
institutions, businesses and currency speculators.
Foreign exchange markets arise from the need to trade, the main motives for
holding foreign exchange include: transaction needs, finance trade, investment
projects, risk management and speculation.

Exercise 1
A German firm is due to receive 25,000 from a UK customer. The banks quoted
exchange rate is 1.0650 1.0700.

A
B
C
D

Exercise 2
The current rate of inflation in the UK is 5% and 4% in US. The exchange rate
between the two countries stands at 1.6800 /$. If exchange rates adjust to
maintain purchasing power parity, the exchange rate in one year from now will be
A

1.6961

1.7632

1.7640

1.6650

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FLOATING EXCHANGE RATE


A floating exchange rate 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.

Factors determining the demand and supply for a currency


The demand for a given currency extends as the exchange rate falls, whereas the
supply of a given currency contracts as the exchange rate depreciates. The reason
for the demand/supply effects is threefold and stems from:

o Trade effects

o Portfolio effects

o Speculative effects

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Other influences on exchange rates


Trade balances

Interest rates

Inflation

Future expectations

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Discussion 1
Complete boxes 2 and 3 below to denote the impact of a domestic currency
ed and
exported goods/services.
Currency appreciation:

1
2

If a currency appreciates in value,


then ..
The price of its exports will ..........

While price of its imports will ......

Currency depreciation:

1
2

13 1

If a currency depreciates in value,


then ..
The price of its exports will ..........

While price of its imports will ......

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Advantages and disadvantages of floating exchange rates


Advantages:
Continuous and automatic adjustment.
Reduced need for government to hold foreign exchange reserves.
Encourages efficient allocation of resources.
Disadvantages:
Expose firms to currency risks.
Uncertainty regarding exchange rate movements may deter trade.
Significant fluctuation may be politically damaging.

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FIXED EXCHANGE RATE


A fixed exchange rate regime entails governments using their reserves to create an
exact match between supply and demand for its currency so as to maintain a fixed
exchange rate. The rate being fixed against a standard such as the price of gold, a
major currency (e.g. US dollar) or a representative sample of major trading
currencies.

Advantages and disadvantages


Advantages:
Provides certainty which may encourage international trade.
Imposes economic discipline on countries.
Disadvantages:
Loss of flexibility over domestic economic policy.
Devaluation may be regarded as economic failure.

Single currency zones


Membership of the Eurozone requires a state to give up its own monetary policy
and accept that of the European Central Bank. The rationale behind the single
currency is that it will lead to increased trade and price transparency.
The overriding argument against a single currency concerns the one size fits all
approach to economic policy.

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