Exchange rates


    Exchange rates

    Demand for and Supply of a currency

    This is what determines exchange rate in a free-floating exchange rate system:

    • When a currency has strong demand it will appreciate in value.
    • In contrast, when there is a large scale selling of a currency it will depreciate.

    Demand for a currency:

    • Exports and imports of goods/services
      • If a country has a decline in export industries and earnings, yet its people continue buying imports, the exchange rate is likely to fall.
        • This is possibly not true for countries such as Hong Kong which are dependent on imports of oil and food.
      • Fewer exports will mean less demand for the currency to pay for them, so the demand for the currency will decrease.
      • This will lead to depreciation
      • When a currency has depreciated, this makes the countries’ exports cheaper abroad.
      • Thus, exports should become more competitive overseas.
    • Price elasticity of demand for imports
      • When a currency depreciates, imports become more expensive.
      • If the demand for imports is price elastic, this should lead to a fall in expenditure on imports
      • This situation is found where imports compete with home-produced alternatives.
      • When countries import necessities, such as food and oil, demand tends to be price inelastic so expenditure rises when the currency falls.
    • Pure speculative demand.
      • Speculators often purchase currencies that they think will appreciate in value against their own currency.
    • Official buying of the currency by the central bank.
      • This might be done for investment or speculation or security or other reasons.
    • Comparatively higher domestic interest rate.
      • Thus savers will be likely to convert their own money into your currency to save in your nation and enjoy the comparatively higher domestic interest rates you offer.

    Supply of a currency

    •  Imports of goods and services.
    •   Outflows of direct investment.
    •  Outflows of portfolio investment.
    •  Speculative selling of the currency.
    • Official selling of the currency by the central bank.
    •  Rate of interest abroad.

    Appreciation and Depreciation

    • Foreigners will tend to save money in one’s nation.
    •  Thus the demand for one’s currency rises which can cause one’s currency to appreciate in general.
    •  Depreciation means that the value of the currency in terms of other currencies goes down:
    • If the USD depreciates against the RMB then it will take fewer RMB to buy each USD.
    • If 1 Euro was worth HKD 10.2 at the start of the year.
    • It may depreciate if the Greek government declared that it would withdraw from the Eurozone and go back to using the Drachma in order to depreciate their currency.
    • This will cause others to lose confidence in the Euro and speculation will cause people to sell the Euro.
    • This may end up causing the Euro to depreciate to HKD 7 per Euro.
    • In this case the Euro has depreciated against the HKD because it now takes more Euros to purchase each HKD.
    • But the HKD has appreciated against the Euro because it now takes fewer HKD to buy 1 euro

    Advantages of a Strong Currency

    • Lower import prices – This boosts living standards of consumers.
    •   An increase in the real purchasing power of HK residents traveling overseas for business and leisure purposes.
    • Cheaper to import raw materials, components and capital inputs – causes an outward shift in short-run aggregate supply.
    • Improvement in the terms of trade (lower import prices).
    •  Helps to control RPI inflation – Domestic producers face stiff international competition and must keep their prices down. Lower inflation allows the MPC/HKMA to keep nominal interest rates at a lower level than if the exchange rate was weak.
    • An increase in a country’s relative position in international league tables showing real GDP per capita when expressed in a common currency:
    • Even if one’s GDP, as measured in one’s own currency, is no more than previously, because one’s currency has appreciated in value, the GDP of one’s nation will also increase when it is translated into another currency.


    Disadvantages of a Strong Currency

    • Cheaper imports lead to rising import penetration and large trade deficit:
    • Import penetration means that a larger portion of the goods and services provided by a nation’s firms is now provided by foreign firms.
    • Exporters also lose price competitiveness and market share thus causing a trade deficit.
    • Damaged profit and employment in some sectors to which exporting is the key means of generating revenue.
    • Negative impact on economic growth (exports – injections of aggregate demand, imports – leakages of wealth form the circular flow of income).
    • Some regions which have a higher than average dependency on exporting industries are more affected than others.


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