0455 · 6.3Foreign exchange rates

Exchange rate quotations and conversion

0:00A British café buys coffee from abroad, while an American visitor pays for a hotel in Britain. Both transactions involve exchanging currencies. A change in their relative values can alter the café’s costs and the visitor’s spending power. By the end of this video, you will understand currency prices, their movements, and their effects on international trade. A foreign exchange rate is the price of one currency in terms of another.

0:23For example, an exchange rate tells us how many American dollars one British pound buys. The currency being priced must always be clear. Throughout our market diagrams, we will examine pounds, with their price measured in American dollars. Suppose, for example, that one pound exchanges for one point seven five dollars. A traveller who changes pounds receives one point seven five dollars for each of them. We will assume there are no transaction charges, so the calculations show the currency conversion alone.

0:52Dollars received equal pounds exchanged multiplied by the number of dollars per pound. At our exchange rate, multiply thirty-two pounds by one point seven five dollars per pound. The result is fifty-six dollars. To reverse the transaction, divide fifty-six dollars by one point seven five dollars per pound, which gives thirty-two pounds. Multiplication works because each pound buys a stated number of dollars. Going the other way, we divide to find how many pounds those dollars purchase.

1:19Writing the units beside your working helps you choose the operation. Read the quotation carefully, since an exchange rate can also be expressed as pounds per dollar.

Why currencies are bought and sold

1:29The foreign exchange market is where currencies are bought and sold. Demand and supply keep their usual meanings, so they are the willingness and ability to buy, or to sell, a currency at each price. Here, the product being traded is a currency, so its exchange rate acts as its price. Buying one currency usually involves selling another. An American tourist who exchanges dollars for pounds creates demand for pounds and supplies dollars.

1:54The reverse happens when a British resident changes pounds into dollars, because pounds are then supplied. Always choose the currency you are analysing before deciding which market curve is affected. Trade in goods and services creates a major reason for buying and selling foreign currencies. Exports are goods and services sold to other countries, while imports are purchases from abroad. An American buyer paying a British furniture maker in pounds needs British currency.

2:19That transaction creates demand for pounds because the buyer requires them to pay the exporter. Services create the same connection, even when no physical product crosses a border. Overseas visitors purchasing British hotel accommodation need pounds to pay their bills. British residents buying an American online service may exchange pounds for dollars. From the pound market’s perspective, this payment adds to the supply of pounds because residents offer their currency for sale.

2:45Investment in capital goods between countries also requires currency transactions. Capital goods are human-made goods used to produce other goods and services. A foreign car maker paying a British firm to equip its new factory in Britain needs pounds, so it demands them. When a British business buys equipment abroad, it sells pounds for the foreign currency it needs, which adds to their supply. The payment of profit, interest and dividends between countries is another reason for exchanging currencies.

3:14Profit is total revenue minus total cost, and dividends are payments to shareholders from a company’s profits. When a British firm brings home the profit from its factory abroad, it sells foreign currency and so creates demand for pounds. A foreign-owned company in Britain that sends dividends to overseas shareholders supplies pounds instead. Interest paid on loans between countries creates the same two flows. Workers’ remittances are money transfers that people employed abroad send to their home countries.

3:41A worker in Britain who sends part of their earnings to family overseas must sell pounds, so the supply of British currency rises. In the other direction, British people working abroad send money home by buying pounds. Their transfers create demand for the British currency. Speculation means buying or selling an asset to profit from an expected change in its price. Currency speculators may buy pounds because they expect their value to rise.

4:06If that prediction proves correct, they can later exchange those pounds for more foreign currency. Expectations can therefore generate transactions before the anticipated change actually happens. Governments also trade currencies, usually through their central bank. Government intervention in currency markets means official buying or selling of a currency to influence its value. When the central bank buys its own currency with its holdings of foreign currency, demand rises and the price is pushed up.

4:32Selling the domestic currency has the opposite effect, because it adds to supply and pushes the value down.

Floating exchange rate equilibrium

4:38A floating exchange rate is determined by the market forces of demand and supply of the currency. Its value can change as buyers and sellers respond to new conditions. Appreciation is a rise in the value of a currency in a floating system. When the pound’s value appreciates against the dollar, each pound buys more dollars. A fall in the value of a currency in a floating system is called depreciation.

5:00Following a depreciation against the dollar, each pound purchases fewer dollars. A fall in the rate from one point seven five to one point six dollars per pound is an example. Because each rate links two currencies, this depreciation of the pound is also an appreciation of the dollar. On this graph, the vertical axis shows the price of the pound in dollars, while the horizontal axis measures the quantity of pounds.

5:24Demand for pounds comes from foreigners buying British exports and investing in Britain. The demand curve slopes downwards because a cheaper pound makes British products less expensive for foreign buyers. At a lower exchange rate, there is therefore an extension of demand for pounds along the unchanged curve. British residents buying imports and investing abroad are the sellers of pounds. As its value rises, each pound buys more foreign currency, so overseas products become cheaper for British buyers.

5:52A higher exchange rate therefore brings an extension of supply along the unchanged curve. The curves cross at point E, so the equilibrium exchange rate is P e and the quantity of pounds traded is Q e. The equilibrium foreign exchange rate is the price at which the quantity of a currency demanded equals the quantity supplied. Below this price, buyers want more pounds than sellers offer, so there is excess demand.

6:15Competition for the scarce pounds pushes the exchange rate up. Above equilibrium, excess supply drives the pound’s price down until the quantities match.

Causes of exchange rate changes

6:25Suppose overseas demand for British exports increases because buyers prefer those products. Foreign customers need more pounds at each exchange rate, so demand increases from D one to D two. The equilibrium moves from point A at P one to point B at P two. The pound then appreciates, and the higher price causes an extension of supply along the unchanged curve. Changes in demand for exports and imports can therefore cause foreign exchange rate fluctuations.

6:52If foreign purchases of British exports fall, fewer pounds are required, so demand decreases and the currency depreciates. A rise in British demand for imports also leads to depreciation, but through supply. Residents sell more pounds to buy the foreign currency needed for those imports. In this import example, supply increases from S one to S two. Point A at P one gives way to point B at P two.

7:16The lower dollar price represents depreciation, with an extension of demand along the unchanged curve. Conversely, reduced British purchases of imports decrease the supply of pounds, so the pound then appreciates. Changes in the interest rate can also influence currency demand. Interest on savings is a payment received for placing money with a financial institution. Higher British interest rates relative to overseas rates make pound deposits more attractive. Investors exchange foreign money for pounds to obtain the higher return, so demand for the currency increases and the pound then appreciates.

7:49On the diagram, this is the same rightward shift of demand as in the export example. Short-term funds that move quickly between countries in search of higher returns are often called hot money. Lower relative interest rates encourage investors to move funds abroad. They sell pounds for another currency, so supply increases and the pound then depreciates. Expected currency movements and financial risks also influence their decisions. Speculation can reinforce exchange rate fluctuations through expectations.

8:18If traders expect the pound to appreciate, their purchases increase demand and can help cause that rise. Expectations of depreciation may instead encourage holders to sell, which increases supply and pushes the price down. Predictions sometimes prove incorrect, so speculative transactions involve a risk of loss.

Effects on trade prices

8:36Exchange rate changes affect the prices and demand for exports and imports through currency conversion. Keep the exporter’s domestic price fixed while examining what an overseas buyer pays. For imports, hold the foreign seller’s price constant and calculate the domestic cost. This separates the exchange rate effect from any independent change in the product’s original price. Suppose a British jacket costs sixty pounds, and the pound then appreciates from one point two five dollars to one point five dollars.

9:04The export price in dollars equals its pound price multiplied by dollars per pound. At the old rate, sixty pounds times one point two five makes seventy-five dollars. After the appreciation, the jacket costs ninety dollars, because sixty multiplied by one point five is ninety. The jacket still costs sixty pounds in Britain, but its American price rises from seventy-five dollars to ninety dollars. Overseas buyers must give up more dollars to obtain the required pounds.

9:32British exports therefore become dearer, so their quantity demanded falls. This is a contraction of demand along the unchanged product demand curve. Now consider American equipment priced at two hundred and ten dollars, under the same change in the exchange rate. To find its import price in pounds, divide the dollar price by the rate in dollars per pound. Before the appreciation, two hundred and ten dollars divided by one point two five gives one hundred and sixty-eight pounds.

9:56At the new rate of one point five, the British buyer pays one hundred and forty pounds. The British buyer now needs fewer pounds to obtain the same dollar amount. Imports become cheaper, so there is an extension of demand along their unchanged product demand curves. Imported capital goods such as energy-saving machinery become cheaper too. Firms can then buy more of it, so they burn less fuel and cause less pollution.

10:20A depreciation reverses these price effects when the original product prices remain unchanged. Foreign customers need less of their own money to buy the exporter’s currency, so exports become cheaper abroad. Imports become dearer because domestic buyers must give up more of their currency to obtain the required foreign amount. Demand for exports therefore extends, while demand for imports contracts. The size of these effects depends on price elasticity of demand, or P E D.

10:47This elasticity is a measure of the responsiveness of quantity demanded to a change in price. Demand is price elastic when quantity demanded changes by a larger percentage than price. A depreciation then brings a large rise in the quantity of exports sold. For exports with price inelastic demand, the quantity sold rises by a smaller percentage than the price falls.

Exam technique and recap

11:09Examiners often see answers that price the wrong currency, shift the wrong curve, or mix up prices with quantities. Track which currency each buyer needs and which one they sell. A change in export orders shifts currency demand, while a change in the rate itself moves the market along an unchanged curve. Name those movements as an extension or contraction of demand or supply. An examination question might ask you to explain how an increase in overseas demand for a country’s exports can affect its floating exchange rate.

11:38Foreign buyers need the country’s currency to pay its exporters. The demand curve for that currency therefore shifts to the right. At the original rate, demand now exceeds supply, so the price of the currency rises and it appreciates. A define question needs the precise meaning, such as the price of one currency in terms of another. For a state question, express a point in clear terms, perhaps one reason for buying foreign currency.

12:03Explain means setting out purposes or reasons, why or how an outcome occurs. When asked to analyse, examine the relationships in detail, including the link between conversion prices and quantities purchased. Discuss means writing about the issue in depth in a structured way, with both sides. On one side, a depreciation lowers the price of exports in foreign currency, assuming domestic prices stay unchanged. Where export demand is price elastic, overseas buyers respond strongly, so the quantity of exports demanded rises by a large amount.

12:34On the other side, demand for many exports is price inelastic. The quantity demanded then rises by a smaller percentage than the price falls, so the increase is small. On balance, a depreciation usually causes a large rise in the quantity of exports demanded only when that demand is price elastic. The reason is that buyers then respond more than proportionately to the lower foreign-currency price. In multiple-choice questions, identify the currency being priced before tracing the relevant demand or supply change.

13:03To sum up, a foreign exchange rate is the price of one currency in terms of another. The market forces of demand and supply of the currency determine a floating exchange rate. In such a system, appreciation is a rise in the value of a currency, and depreciation is a fall. Demand for a currency comes from foreigners buying exports and investing in the country, while supply comes from residents buying imports and investing abroad.

13:28Trade, international payments, investment, remittances, speculation and government intervention all create reasons for currency transactions. Changes in export demand, import purchases, interest rates and expectations shift the curves and make the rate fluctuate. A strong currency makes imports cheaper and exports dearer. Always connect the currency transaction to its market effect, then connect the exchange rate to the price buyers actually pay.