Economic

Lecture 17
Exchange Rate

Last Updated:7 February 2024

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 1.0 Learning Objectives

When you have complete this chapter, you will be able to:
➢ define exchange rate and understand the
history of exchange rate system.
➢ understand fixed exchange rate and
flexible exchange rate.
➢ Explain the factors affecting exchange rate
➢ understand the equilibrium in exchange
rate market.
7 September 2012
1.1 Exchange Rate
• Definition : price of one currency in terms of another
currency.

• The dollar($), the euro (€), and the yen (¥) are three
world’s monies and most international payments are
made using one of them.

• Example : an importer in Malaysia who wants to buy

digital cameras from Japan will need to convert RM to
Japanese Yen to carry out business with Japanese
firms.

¥100 US$1
1.1 Exchange rate
•The price at which one currency exchanges
for another is called a foreign exchange
rate.
•A fall in the value of one currency in terms of
another currency is called currency
depreciation.
•A rise in value of one currency in terms of
another currency is called currency
appreciation.
1.1 Exchange Rate

• The exchange rates fluctuates – rises and falls

• A rise in exchange rate is an appreciation of the dollar

and a fall in the exchange rate is called depreciation of
the dollar.

• Example : exchange rate rises from 84 yen to 100 yen

per dollar, the dollar appreciates and vice versa
1.1 Foreign currency

• When we talk about foreign money, we refer to it as a

foreign currency.

• Foreign currency : money of other countries regardless

of whether that money is in the form of notes, coins or
bank deposits.

• The currency of one country is exchanged for another

currency in foreign exchange market where is made up
of thousands of people (importers and exporters)
1.1 Gold Standard
• Prior to 1930’s, the values of all currencies were directly
fixed to gold and have a fixed relationship to each other.

• Example : US defines $20 in terms of one ounce of gold

and Britain defines 4 pounds for one ounce of gold, then
the exchange rate between dollars and pounds will be $
5 to 1 pound.
1.1 An Exchange Rate Is a Price
An exchange rate is the price
• —the price of one currency in terms of another.

•Like
all prices, an exchange rate is determined in
a market —the foreign exchange market.

•The Ringgit Malaysia is demanded and supplied

by thousands of traders every hour of every day.

•With many traders and no restrictions, the foreign

exchange market is a competitive market.
2.0 The Demand for One Money Is
the Supply of Another Money
•When people who are holding one money want to
exchange it for Ringgit Malaysia, they demand RM and
they supply that other country’s money.

•So the factors that influence the demand for RM also

influence the supply of Singapore dollars, U.K. pounds,
and Japanese yen.

•Andthe factors that influence the demand for another

country’s money also influence the supply of RM.
2.1 Demand in the Foreign Exchange
Market
• People buy RM in foreign exchange market so that they
can buy RM produced goods and services, vacations,
assets and investment – RM exports
•The quantity of RM that traders plan to buy in the foreign
exchange market during a given period depends on
1.The exchange rate

2.World demand for RM exports

3.Interest rates in the Malaysia and other countries

4.The expected future exchange rate

2.2 The Law of Demand for Foreign
Exchange

•Otherthings remaining the same, the higher the

exchange rate, the smaller is the quantity of RM
demanded in the foreign exchange market.

•Example : if the price of the RM rises from $0.20 to

$0.30 but nothing else changes, the quantity of RM that
peoples plans to buy decreases.
2.2 The Law of Demand for Foreign
Exchange
•Theexchange rate influences the quantity of
RM demanded for two reasons:

▪Exports effect
▪Expected profit effect
2.2 The Law of Demand for Foreign
Exchange
2.2.1 Exports Effect

•The larger the value of RM exports, the greater is

the quantity of RM demanded in the foreign
exchange market.

•The value of RM exports depends on the prices

of RM goods and services which expressed in the
foreign currency. And the price depend on the
exchange rate

•Therefore, lower the exchange rate, the lower are

the prices of RM goods and services to foreigners,
the greater is the volume of RM exports, so the
greater is the quantity of RM demanded.
2.2 The Law of Demand for Foreign
Exchange
2.2.2 Expected Profit Effect

•The larger the expected profit from holding RM, the

greater is the quantity of RM dollars demanded today.

•But expected profit depends on the exchange rate.

•The lower today’s exchange rate, other things remaining

the same, the larger is the expected profit from buying
RM and the greater is the quantity of RM demanded
today.
2.2 The Law of Demand for Foreign
Exchange

Example:

•Suppose that Bank Negara, a Malaysia Bank, expects

the exchange rate to be 0.04 yen per ringgit at the end of
the year.

•If today’s exchange rate is also 0.04 yen per ringgit,

BNM expects no profit in future and hold ringgit till the
end of the year.

•But if today’s exchange rate is 0.037 yen per ringgit,

BNM buys ringgit and expects to sell those ringgit at the
end of the year and make profit of 0.003 yen per ringgit.
2.2 The Law of Demand for Foreign
Exchange

•The Demand Curve for U.S. Dollars

•Figure 9.1 illustrates the demand curve for U.S. dollars on the foreign exchange
market.
3.0 Supply in the Foreign Exchange
Market
•The quantity of RM supplied in the foreign
exchange market is the amount that traders plan
to sell during a given time period at a given
exchange rate.

•This quantity depends on many factors but the

main ones are:
1.The exchange rate
2.World demand for RM Imports
3.Interest rates in the Malaysia and other countries
4.The expected future exchange rate
3.1 The Law of Supply of Foreign
Exchange
•Other things remaining the same, the higher the
exchange rate, the greater is the quantity of RM supplied
in the foreign exchange market.

•Theexchange rate influences the quantity of RM

supplied for two reasons:
▪ Imports effect
▪ Expected profit effect
3.1 The Law of Supply of Foreign Exchange

3.1.1 Imports Effect

•Thelarger the value of Malaysia imports, the larger is the
quantity of RM supplied on the foreign exchange market.

•But the value of RM imports depends on the prices of

foreign goods and services which expressed in the ringgit
currency. And these price depend on the exchange rate.

•Therefore higher the exchange rate, the lower are the

prices of foreign-produced goods and services, the
greater is the volume of Malaysia imports, so the greater
is the quantity of RM supplied.
3.1 The Law of Supply of Foreign Exchange
3.1.2 Expected Profit Effect
•For a given expected future RM exchange
rate, the higher the exchange rate today,
the larger is the expected profit from selling
RM today and holding foreign currencies,
so the greater is the quantity of ringgit
supplied.
4.1 The Law of Supply of Foreign
Exchange

•Supply Curve for U.S. Dollars

•Figure 9.2 illustrates the supply curve of U.S. dollars in the foreign exchange market.
5.0 Market Equilibrium
•Figure 9.3
shows how
demand and
supply in the
foreign
exchange
market
determine the
exchange rate.
 5.0 Market Equilibrium
•If the exchange rate
is too high, a surplus
of U.S. dollars drives
it down.

•Ifthe exchange rate

is too low, a
shortage of U.S.
dollars drives it up.

•The market is pulled

(quickly) to the
equilibrium exchange
rate at which there is
neither a shortage
nor a surplus.
6.0 Exchange Rate Fluctuations
Changes in the Demand for U.S. Dollars
•A change in any influence on the quantity of U.S.
dollars that people plan to buy, other than the
exchange rate, brings a change in the demand for
U.S. dollars.
•These other influences are

▪ World demand for U.S. exports

▪ U.S. interest rate relative to the foreign interest
rate
▪ The expected future exchange rate
Exchange Rate Fluctuations

World Demand for U.S. Exports

•At a given exchange rate, if world demand for U.S.
exports increases, the demand for U.S. dollars increases
and the demand curve for U.S. dollars shifts rightward.
U.S. Interest Rate Relative to the Foreign
Interest Rate
• The U.S. interest rate minus the foreign interest rate is
called the U.S. interest rate differential.
• If the U.S. interest differential rises, the demand for U.S.
dollars increases and the demand curve for U.S. dollars
shifts rightward.
Exchange Rate Fluctuations

•The Expected Future Exchange Rate

•At a given current exchange rate, if the
expected future exchange rate for U.S. dollars
rises,
•the demand for U.S. dollars increases and
the demand curve for dollars shifts rightward.
 Exchange Rate Fluctuations

•Figure 9.4 shows

how the demand
curve for U.S.
dollars shifts in
response to
changes in
▪ U.S. exports
▪ The U.S. interest rate
differential
▪ The expected future
exchange rate
Exchange Rate Fluctuations

Changes in the Supply of Dollars

•A change in any influence on the quantity of
U.S. dollars that people plan to sell, other than
the exchange rate, brings a change in the
supply of dollars.
•These other influences are

▪ U.S. demand for imports

▪ U.S. interest rates relative to the foreign
interest rate
▪ The expected future exchange rate
Exchange Rate Fluctuations
U.S. Demand for Imports
• At a given exchange rate, if the U.S. demand for
imports increases, the supply of U.S. dollars on the
foreign exchange market increases and the supply
curve of U.S. dollars shifts rightward.
U.S. Interest Rate Relative to the Foreign
Interest Rate
• If the U.S. interest differential rises, the supply for
U.S. dollars decreases and the supply curve of
U.S. dollars shifts leftward.
 Exchange Rate Fluctuations

•The Expected Future Exchange Rate

• At a given current exchange rate, if the expected
future exchange rate for U.S. dollars rises,
• the supply of U.S. dollars decreases and the
supply curve for dollars shifts leftward.
 Exchange Rate Fluctuations

•Figure 9.5 shows

how the supply curve
of U.S. dollars shifts
in response to
changes in
▪ U.S. demand for
imports
▪ The U.S. interest rate
differential
▪ The expected future
exchange rate
7.0 Exchange Rate Policy
Three possible exchange rate policies :
• Flexible exchange rate

• Fixed exchange rate

• Crawling peg
7.1 Flexible Exchange Rate
• exchange rate that determined by demand and supply
with no intervention by CB
• But, it also influenced by CB actions. Example : CB
raised the interest rate , the demand for ringgit increases
and the supply for ringgit decreases .
• Thus, the exchange rate rises. (Similarly for CB lowered
the interest rate but in opposite direction).

•Nonetheless, when CB changes interest rate, its purpose

is not usually to influence the exchange rate but to
achieve other monetary policy objective.
7.2 Fixed Exchange Rate
• exchange rate that determined by decision of the
government / CB to block the unregulated forces of
demand and supply.

• CB have to sell ringgit to prevent the exchange rate from

rising above the target value and buy ringgit to prevent
the exchange rate from falling below the target value.

• No limit to sell quantity of ringgit . Why?

• Limitation on buying ringgit because CB must sell foreign
currency in order to buy ringgit. When Malaysia official
foreign currency reserves run out, the purchase of ringgit
will stops.
Exchange Rate Policy

•Suppose that the

target is 100 yen
per U.S. dollar.
•If the demand for
U.S. dollars
increases, the Fed
sells U.S. dollars
to increase supply.
 Exchange Rate Policy

•Ifdemand for the

U.S. dollar
decreases, the Fed
buys U.S. dollars to
decrease supply.
•Persistent
intervention on one
side of the foreign
exchange market
cannot be sustained.
7.3 Crawling Peg
• exchange rate that follows a path determined by a
decision of government/CB and is achieved in a similar
way to a fixed exchange rate by CB interventions.

• A crawling peg works like a fixed exchange rate except

that the target value changes, which might be fixed
intervals (daily ,weekly, monthly) or at random intervals.