Exchange Rates....that'll be 10,000 Japanese yen please?!

An exchange rate is the value of one currency in terms of another.  For example, as of May 9, 2010, 1CHF (Swiss franc) = € (EU euro) 0.71.  The graph above shows the floating exchange rate of CHF as expressed in EUR as of May 2010.  In such a floating / mixed exchange rate regime, the value of the currency is allowed to be determined by the market forces of supply and demand as determined on the foreign exchange market.  In this case, it is the demand for CHF in terms of euro.  The demand curve is downward-sloping representing the demand for CHF by Europeans in the Eurozone (or people holding EUR).  The supply curve is upward-sloping and represents the supply of CHF which comes from Switzerland.  The equilibrium price, the exchange rate, is CHF1 = .71 EUR.  If the value of a currency in a floating exchange rate increased (i.e. CHF1 = 1.00 EUR), then we would say the CHF has appreciated.  On the flip side, if the value decreased, it has depreciated.  Changes in the value of currency depends on different factors and would be represented by a shift in demand or supply curves.  Factors that affect the value of the currency include an increase in exports bought by Europeans, an increase in European investment in Switzerland, an increase in European saving in Swiss banks, an interest to speculate on the value of the CHF.  

What increases the demand for a currency, i.e. Russian ruble (rightward shift in D)?

- an increase in demand for Russian g/s

- lower rates of inflation in Russia compared to other countries with similar products

- foreigners make more money, so they demand more of all g/s, including Russian ones

- foreigners develop tastes/preferences for Russian g/s

- Russian investment prospects improve and the interest rate increases (more savings)

- speculators believe the RUR will appreciate in the future, demand more now to make money (buy low, sell high)

What decreases the demand for a currency, i.e. Indian rupee (rightward shift in D)?

- Indians demand more foreign g/s

- higher rates of inflation in India compared to other countries with similar products

- Indians make more money, so they demand more of all g/s, including foreign ones

- Indians develop tastes/preferences for foreign g/s

- Foreign investment prospects improve and the interest rate decreases relative to other countries (less desire for domestic savings)

- speculators believe the INR will depreciate in the future, demand les

More generally, there are three different types of exchange rate regimes : floating, managed (mixed) and fixed.  In a floating exchange rate regime, the value of the one currency in terms of another is determined solely by the forces of supply of and demand for that currency.  Here, if the value goes up, the currency has appreciated, and if it goes down, it has depreciated.  Conversely, in a fixed regime, the exchange rate is determined by the government (or a governmental body).  If this currency gets stronger, it has revalued and if it has gone down, we say it has devalued.  In the middle, where exchange rates are allowed to float but are "managed" if their value goes too low or too high, then we have a managed exchange rate regime.  Managed towards floating is what most currencies are today.  

ADVANTAGES                  DISADVANTAGES

...of a high exchange rate (currency is strong compared to others)

- inflation is pushed downwards - export industries lose because their

because imports, FoPs cheaper   g/s become more expensive, U up

- purchasing power for imports     

strengthens                                  - domestic producers in general can

- domestic producers must be      lose because domestic consumers

more efficient to compete with    may switch to cheaper imports;

foreign producers, we win!          unemployment (U) may go up

...of a low exchange rate (currency is weak compared to others)...JUST REVERSE THOSE ABOVE FOR A STRONG CURRENCY!!!

          

 Let's continue...

ADVANTAGES                 DISADVANTAGES

...of a fixed exchange rate regime

 - very predictable (b/c    - may see unemployment through ∆i

fixed) means easier to do - hard to do, thus very inefficient because

business with respect to    market can't clear

exchange rate costs           - the government must be

of inflation because it       mindful  - needs large foreign reserves

could destroy the              to maintain rate

macroeconomy,               - can make other countries angry

so low inflation                (i.e. US v. PRC)

 - its hard to speculate 

on a fixed rate!

ADVANTAGES                      DISADVANTAGES

...of a floating exchange rate regime

- ∆i can be used as a tool to "fix"  - can create uncertainly (S and D)

economy depending on problem   - may see unemployment through ∆i

- easier to manage balance           - can be attacked by speculators

of payments                                  - can make inflation worse (if high)

ADVANTAGES                      DISADVANTAGES

...of a single currency (ie. €)

- cuts transaction costs             - country must follow union

- more certainty in value          monetary policy (i.e. no control i)

- easier to compare prices       - can be expensive to switch from

- more FDI (easier to do         one currency to another

business)                                 - hard to fight BoP deficit

purchasing power parity (PPP) theory : a theory states that different floating currencies will, over time, adjust until one unit of currency can buy the exactly the same amount of products as one unit of another currency.  "The Economist" web site defines the term as "a method for calculating the correct value of a currency, which may differ from its current market value [which...] is helpful when comparing living standards in different countries, as it indicates the appropriate exchange rate to use when expressing incomes and prices in different countries in a common currency."

PPP Map from Wikipedia :

From 2003 and using USD as the base currency, this map shows us how much more expensive (reds and oranges) or less expensive (yellows and below) the exact same basket of g/s is in the country (i.e. Scandinavian prices for the exact same basket of g/s are more than 20% higher than in the US, whereas Mexico's basket is 70% of the price of the American basket so 30% less).

Click here to discover The Economist's "Big Mac Index"!