In this video we’ll examine floating exchangerates and see how they are determined.
In future videos we will take a look at fixedand managed float systems.
Floating exchange rates are determined bythe market forces of supply and demand in the foreign exchange market.
The value of the currency is determined solelyby market forces and not intervention by the government.
When discussing appreciation or depreciationof currencies, we are generally referring to floating exchange rate systems.
Appreciation occurs when a currency gainsin value relative to other currencies.
Depreciation occurs when a currency losesvalue relative to other currencies.
Why appreciation and depreciation occur, we’llsee in the remainder of this presentation.
Let’s start with our supply and demand diagramfrom unit 2, but we’ll make some slight adjustments for foreign exchange, consideringthe market for US dollars being purchased by people or institutions from the UK.
From unit 2 we can recall that market forcesdetermine an equilibrium price and equilibrium quantity for a good.
Next we’ll see how this applies to the marketfor dollars.
We change the Y-axis label from price to ‘ExchangeRate’ because the exchange rate represents the price of dollars in pounds.
We change quantity to quantity of dollarsto clarify the currency market we are discussing.
Finally, we change equilibrium price, P* toER* to reflect the equilibrium exchange rate.
If you’re drawing a diagram for exchangerates, I highly encourage you to use this format.
We’ll examine changes in demand – In thisexample we are simplifying the foreign exchange market for dollars to two countries, the USand UK.
Since we are discussing the market for dollars,the UK is on the demand side.
UK parties represent the groups interestedin purchasing dollars.
Factors that affect the demand for a currencycan also influence its supply.
We’ll discuss that later.
Right now, we will focus on the reasons thatdemand for a currency increases.
For the sake of discussion, we’ll continuewith our British pound and US dollar analysis.
The demand for currency is derived partiallyfrom the demand for a country’s goods and services.
If there is an increase in the attractivenessof American goods to British consumers, then the demand for the dollar will increase.
This could be due to a host of factors includingrelative price levels, improved quality and changes in tastes and preferences.
All other things being held constant, a decreasein the US rate of inflation will make American products more price competitive and shoulddrive up their demand.
This could in turn drive up the demand fordollars, causing an appreciation of the dollar.
This can also work the other way, with a risein the price level of the US reducing the demand for goods and services by British buyersand thus cause the dollar to depreciate.
If interest rates are relatively higher thanthey are in other countries, this could attract money flows into the US as foreign investorsseek the more attractive returns offered by American banks.
These are called hot money flows and tendto increase into a country with rising interest rates.
Deposits in American banks are predominantlymade in dollars and British depositors will have to change their pounds to dollars inorder to deposit them in the US.
In general you can say that interest rateshave a direct relationship with exchange rates; exchange rates tend to follow movements inthe interest rate.
Finally, speculation can result in an increaseor decrease in the demand for a currency.
For example, the Chinese government devaluedthe Chinese RMB in the past two years and this has led some Chinese citizens to purchaseand hold US dollars.
They view the dollar as more stable and possiblyseek to benefit from what they perceive as a long-term opportunity of holding dollarsin order to buy RMB back at a favourable rate in the future.
If the Olympics are being hosted in the UnitedStates, the increase in tourists from the UK to the US will increase the demand forUS dollars as British tourists exchange their pounds for dollars in order to purchase moreAmerican goods and services during their travels to the US.
This will shift the demand for dollars tothe right, causing the American currency to appreciate.
It will also cause an increase in the equilibriumquantity of US dollars in the foreign exchange market.
Suppose now that there is a decrease in interestrates offered by American financial institutions for depositors.
This will reduce the demand of US dollarsby British investors as the United States is now less attractive to invest in relativeto other countries, or even the UK itself.
This reduction in the demand for the dollarcauses it to depreciate and the equilibrium quantity exchanged to decrease.
Next we will examine changes in supply – onceagain 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 influencethe demand for the dollar affect the supply of the dollar as well.
To understand why this is you have to rememberthat the demand for the dollar is met by supplying the pound.
Therefore, if Americans increase their demandfor the pound they must supply dollars in exchange.
The same factors we listed earlier can beused 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 fallsrelative to the US, British goods will be more price competitive.
If it’s more rewarding to save money inthe UK, then Americans will increase their deposits at UK financial institutions.
Finally, if Americans believe the UK poundis currently undervalued and will rise in value in the future, they may choose to buyit today in order to benefit from its rise in the future.
In this example, Americans are either increasingor decreasing their supply of dollars in the foreign exchange market.
Imagine there is a sudden increase in thedemand for British goods and services by Americans.
Americans will increase the supply of dollarson the foreign exchange market in order to buy pounds and the dollar will depreciateagainst the pound.
This will also cause an increase in the equilibriumquantity of dollars in the foreign exchange market.
Now suppose the demand for UK imports in theUS decreases, perhaps due to a boycott of UK products.
If that were the case, there would be a fallin demand for UK pounds in the market for pounds and there would be a decrease in thesupply of dollars in the market for dollars.
This would result in an appreciation of thedollar as it would now take more pounds to buy one US dollar.
It would reduce the equilibrium quantity ofdollars in the forex market as well.
Thanks for watching this video on floatingexchange rates.
As always I hope you have found it helpful.
If you have any questions, you can leave thembelow or email me at enhancetuition@gmail.
You can also tweet me @enhancetuition.
As always, happy studying and I will see youin the next one.