www.studyinteractive.org 125 Chapter 11 Financial systems 3 foreign exchange markets
Dec 05, 2015
www.studyinteract ive.org 125
Chapter 11
Financial systems 3 foreign exchange
markets
CHAPTER 11 FOREIGN EXCHANGE MARKETS
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CHAPTER CONTENTS
LEARNING OUTCOMES ------------------------------------------------- 127
FOREIGN EXCHANGE RATES ------------------------------------------- 128
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
B 1.7632
C 1.7640
D 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:
Currency depreciation:
1
If a currency appreciates in value, then ..
2The price of its exports will ..........
3While price of its imports will ......
1
If a currency depreciates in value, then ..
2The price of its exports will ..........
3While 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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