EXCHANGE RATES AND THE MARKET FOR FOREIGN EXCHANGE

Lecture 05 /06

Foreign exchange is a general term refer to an aggregate of foreign currencies.

Foreign exchange market is the market in which national currencies are traded for one another.

Thus total afghan residents expenditure abroad represents a demand for foreign exchange.

In other words the total foreign expenditure of afghan residents represents an equal supply of Afs in the foreign exchange market.

Conversely all foreign earnings of afghan citizens reflect equal earnings of foreign exchange.

Total credits in the balance of payments account are then equal supply of foreign exchange or what is the same thing, the demand for Afs.

Demand and Supply of foreign exchange

A higher exchange rate means that the price of foreign currency has risen.When the exchange rate rises, we say that the foreign currency has appreciated or the Afs has depreciated.

A fall in the exchange rate means that the price of foreign currency (price of dollar) has declined. The dollar has depreciated while the afs has appreciated.

The demand schedule for foreign exchange is downward sloping plotted against the exchange rate, because the demand for foreign exchange to finance imports falls as the exchange rate rises ,making foreign goods more expensive.

Suppose we consider the price of a German camera that costs 250 euros. If exchange rate is 0.80,the camera will cost $200.If the exchange rate rises to 1.00 the camera will cost $250.The higher the exchange rate, the higher the dollar cost of imported goods and the lower the demand for foreign exchange.

The supply schedule for foreign exchange is upward sloping reflecting the assumption that the foreign exchange proceeds from exports sales rises as exchange rate rises making domestic goods less expensive to foreign buyers.

As exchange rate rises, US export goods become less expensive to European in terms of Euros. For example US wheat that sells for $4 a bushel would cost a European 5 Euros per bushel at exchange rate of 0.80 but only 4 Euros at an exchange rate of 1.00

For the supply of foreign exchange to increase as the exchange rate rises, the foreign demand for our export must be more than unit elastic, meaning that a 1 percent increase in the exchange rate must result in an increase in demand of more than 1 percent.

Foreign Exchange Rate

It is the rate at which one country’s currency is exchanged for another,e.g, an exchange rate of

57 afs= $ 1 means that one dollar is exchanged for 57 afs.

The equilibrium rate of exchange rate under free market is the the rate at which demand for foreign currency equals supply of the same.

Determination Of Free Exchange Rate

The demand for foreign exchange (dollar)comes from afghan importers, purchase of foreign assets and foreign transfer.

The supply of dollar comes form afghan exporters

Fixed Exchange Rate

Under this system, the rate of local currency(afs) against foreign currency(dollar) is fixed by the monetary authorities of the country. All transaction take place at that rate.

Arguments in Favor of Fixed Exchange Rate

1. fixed exchange rate encourage international trade since prices of goods imported or exported are predictable.

2.Fixed exchange rate encourages long term capital inflow or outflows in a smoother manner. For example, the foreign investors in Afghanistan will not be worried because of any uncertainty or risk arising from frequent changes in exchange rate.

3.There is no fear of any adverse effect of speculation( means that people hold or sell foreign exchange to take advantage of the expected changes I the rate in future) on exchange rate because monetary authorities prevent speculation activities.

4. As a means of adjusting the balance of payments, exchange fluctuations involve constant shifts of labor and other resources between production for the home market and production for export. Such shifts may be costly and disturbing; they tend to create frictional unemployment(search), and are obviously wasteful if exchange market conditions that call for the them are temporary.

Arguments against fixed exchange rate

1. It makes difficult for a govt to freely make internal economic policies. The govt may have to choose between full employment and inflation .Rising prices affect exports and decrease supply of foreign exchange. Either the govt will not be able to maintain fixed exchange rate or if it maintains fixed rate, the policy of full employment will be difficult to follow.

2. large reserves of foreign currencies are required to maintain fixed exchange rate. For example, if there is deficit in the balance of payment and the demand for foreign currencies increases, then the govt will have to provide the extra amount of foreign exchange, otherwise the rates of exchange will rise.

3.Fixed exchange rate requires strict exchange control measures.

4.Fixed exchange rate can not be fixed forever. As the conditions about exports and imports change, the country may need to devalue or revalue its currency to correct BoP.

Floating Exchange Rate

It is determined by the free working of the forces of demand and supply of foreign exchange.

If there is excess supply of some currency, its value in foreign exchange market falls(depreciates).On the other hand, shortage of foreign currency will raise the rate(appreciate).the central bank or the govt do not interfere.

Arguments in favour of floating exchange rate

1. the system is simple to operate. Exchange rates move automatically and freely to equalize demand and supply of foreign currencies.

2. Exchange rate adjusts itself according to the conditions in exchange market. The change is smooth,e.g ., whenever demand for a foreign currency starts rising, exchange rate starts moving up.

3. Under floating exchange rate system, the govt can independently follow any policy about prices and employment in the domestic economy. It does not care much about the effect of such policy on the exchange rate.

4. No need to keep huge amount of foreign exchange

5. No need to borrow form IMF etc

6. Flexibility of exchange rates would allow policy makers to concentrate on domestic goals, free of worries about balance of payment deficits. Exchange rate flexibility would remove potential conflict that arise between internal balance (domestic goals) and external balance(BoP Equilibrium)

7.Flexibible exchange rates would insulate domestic economy form economic shocks that originate abroad.

Arguments against floating rate

1. it is difficult to follow a truly flexible exchange rate policy because internal fiscal and monetary policies influence the rate.

2.Frequent changes in exchange rate creates risks for importer and exporters.

3.floating exchange rate encourages speculation in foreign exchange market.

4.It encourages inflation in a country.

Depreciation

Depreciation is the falling of external value of a currency(afs) in free foreign exchange market.

Depreciation can occur if the govt allows free float of exchange rate and the demand for foreign exchange rises.

Devaluation

Devaluation is the decrease in external value of a currency(afs) announced by the govt.This happens when the country follows policy of fixed rate.

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