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Exchange Rates

Unit 14 - Lesson 1

Learning outcomes:

Explain that the value of an exchange rate in a floating system is


determined by the demand for, and supply of, a currency.
Draw a diagram to show determination of exchange rates in a floating
exchange rate system.
Distinguish between a depreciation of the currency and an
appreciation of the currency.
Draw diagrams to show changes in the demand for, and supply of, a
currency.
Describe the factors that lead to changes in currency demand and
supply

Freely Floating Exchange Rates


Foreign currencies are used for purchases of goods and services around
the world.
Exchange Rates like any other market is made up of the Demand and
Supply of different currencies.
The Demand of a foreign currency creates a supply of domestic currency.
Demand of $ (dollars) creates a supply of Tsh
The Demand of a domestic currency creates a supply of foreign currency.
Demand of Tsh creates a supply of $ (dollars)

Exchange Rates
A mechanism of establishing the values of one currency in relation to
another.
August 2014:
Number of Tsh per US $: $1 = 1,650 Tsh
January 2016:
Number of Tsh per US $1: $1 = 2,165 Tsh
In this unit we will look to understand what causes changes in the value of
one currency in relation to another.

Freely Floating Exchange Rate


A country's exchange rate regime where its currency is set by the
foreign-exchange market through supply and demand for that particular
currency relative to other currencies. (Investopedia)
No Government Intervention into the foreign-exchange market.
Forces of Supply & Demand without any intervention settle at a point
where the Quantity Demanded of that currency is equal to the
Quantity Supplied.
At this point the exchange rate is at equilibrium.

Currency Graphs
Vertical Axis: Price of Dollars in terms of Euros
Horizontal Axis: Quantity of Dollars
Demand Curve represents the Demand for Dollars
Supply Curve represents the Supply of Dollars
Demand is downward sloping.
Demand for Dollars arises from:
1.
2.
Tragakes: pg. 382

3.

Euro zone importers


European Investors interested in investing in the
US
Europeans going on holiday

Currency Graph
Supply Curve for Dollars is upward sloping
Supply for Dollars arises from:
1. US residents importing goods from Europe
2. US residents taking holidays in Europe
3. US resident planning to invest in Europe
The intersection of the Supply & Demand for
Dollars represents the equilibrium free floating
exchange rate.

When graphing currency you


will always use two graphs.
This explains the Price of
one currency in relation to the
Price of another currency.
Left Graph: Price of Euro in
relation to the one Dollar $1 = 1.50 Euro
Right Graph: Price of Dollar in
relation to one Euro - 1 Euro = $.67

1. The intersection of the Supply & Demand for Dollars represents the
equilibrium free floating exchange rate.
2. If the exchange rate were set higher than the equilibrium price & quantity
there would exist excess supply in the market.
3. If the exchange rate were set lower than the equilibrium price & quantity
there would exist excess demand in the market.

Appreciation & Depreciation of Currency


Appreciation of Currency occurs when the value of the currency in a
floating exchange rate system increases.
This occurs when:
1. Increase in Demand for Dollars
a. Increase in European Tourism
b. Increase in Demand from European for US products
2. Decrease in Supply for Dollars
a. Fed Reserve tightens interest rates
b. Increases Reserve Requirements
We will look at additional reasons for Appreciation & Depreciation of
Currencies later.

Appreciation & Depreciation of Currency


Depreciation of Currency occurs when the value of the currency in a
floating exchange rate system decreases.
This occurs when:
1. Decrease in the Demand for Dollars
a. Decrease in imports from the Euro zone
b. Decrease in the amount of European tourists visiting the USA.
2. Increase in Supply of Dollars
a. Fed lowers interest rates
b. Fed decreases the reserve requirement

Example:
There is a significant
increase in the amount of
European Tourists
visiting the USA.
Due to a change in
consumer preferences in
the Europe there is an
increase in Demand for
US products

Tourism: when European come to the USA they Supply Euros to the market
(Increase in Supply of Euros) and Demand Dollars (Increase in Demand for $).
Imports: when Europeans import US products they pay for them in dollars.
Europeans Supply Euros to the market and Demand dollars in return.
Result is an Appreciation of the US $ and a Depreciation of the Euro.

Causes of Changes in Exchange Rates


Foreign Demand for a Countrys Exports:
If there is an increase in Demand for Tanzanian exports, the Demand for
the Tsh will increase resulting in an Appreciation of the Tsh.

Domestic Demand for Imports:


If there is an increase in Demand for foreign goods/imports from
Tanzania, Tanzania will Supply Tsh to the market (increase in supply of
Tsh) and demand the foreign currency. This results in a Depreciation of
the Tsh.

Relative Interest Rate:


If Tanzania had higher the Interest Rate within a country the more
attractive it will be for financial investment.
Capital from abroad flows into the country
Foreigners Supply their currency to the market and Demand the Tsh.
Depreciation in Foreign currency and Appreciation in the Tsh.

Investment from Abroad (Foreign Investment):


A Decrease in Foreign Direct Investment from abroad to Tanzania
Decrease in Demand for Tsh
Depreciation of the Tsh

Relative Rate of Inflation:


Tanzania Inflation Rate increase from 8% to 20%
Kenyas Inflation Rate decreases from 10% to 8%
The effect on currency is:
Decrease in Demand for Tanzanian Exports due to it becoming more
expensive to foreign countries - increase in price of exports.
Increase in Demand for Kenyan Imports due to cheaper prices.
Decrease in Demand (Left Shift) for the Tsh - Depreciation in the Tsh
Increase in Supply (Right shift) of Tsh due to increase in Imports Depreciation of Tsh.

Changes in Income:
If income levels increase in Tanzania relative to other countries then
Tanzania residents will Demand more Imports.
Increase in Imports - Increase in Supply of Tsh to purchase imports Depreciation of the Tsh.

Speculation:
If Currency Traders expect a currency to appreciate this result in
increased Demand for the currency and contributes to the Appreciation of
the currency.
Vice Versa.

Summary
1. As Demand for a countrys exports increases, its currency appreciates.
2. As a countrys imports increase, its currency depreciates.
3. A countrys interest rates and the value of the currency change in the
same direction.
4. Increase in Interest Rates - Appreciation of the currency
5. Decrease in Interest Rates - Depreciation of the currency
6. Higher Inflation Rate in a country relative to another leads to currency
Depreciation.
7. An Increase in Foreign Investment from abroad results in currency
Appreciation.
8. A countrys level of Income relative to other countries causes the value of
the currency to change in opposite directions.