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Revision Exchange rates
16
What factors shift the demand for, and supply of,
a currency?
The demand for a currency (Assume that we are discussing
the euro.)
People will demand, or want to buy, the euro in the foreign
exchange market in order to:
People think the value of the euro will rise in the future, so
they buy it now.
The supply of a currency (Assume that we are discussing
the euro.)
The euro will be supplied on the foreign exchange market in
order for:
Exchange rates
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People think the value of the euro will fall in the future, so
they sell it now.
P
r
i
c
e
o
f
e
u
r
o
i
n
U
S
$
1.25
1.30
1.35
Quantity of euro
D
D (for euro from the US)
S (of euro from EU)
D
D (for euro from the US)
P
r
i
c
e
o
f
e
u
r
o
i
n
U
S
$
1.25
1.30
1.35
Quantity of euro
S (of euro from EU)
S
S
0 0
Advantages and disadvantages of high and low
exchange rates
High exchange rate Low exchange rate
Advantages There will be downward pressure on infation,
because imports are cheaper.
More imports can be bought.
It forces domestic producers to improve
their efciency.
There will be greater employment in export
industries.
There wil be greater employment in domestic
industries.
Disadvantages It will damage export industries.
It will damage domestic industries.
Infation will occur because of higher import prices
and prices of raw materials and nished goods.
Reasons for government intervention in the
foreign exchange market
There are a number of reasons why governments may intervene
in the foreign exchange market to influence the value of their
currency. They may wish to:
Exchange rates
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Means of government intervention in
the foreign exchange market
There are two main methods.
1. By using their reserves of foreign currencies
to buy, or sell, foreign currencies if the
government wishes to increase the value of
the currency, then it can use its reserves of
foreign currencies to buy its own currency on
the foreign exchange market. This will
increase the demand for its currency and so
force up the exchange rate.
In the same way, if the government wishes to
lower the value of its currency, then it simply
buys foreign currencies on the foreign
exchange market, increasing its foreign
currency reserves. To buy the foreign currencies,
the government uses its own currency
and this increases the supply of the currency
on the foreign exchange market and so lowers
its exchange rate.
2. By changing interest rates if the government
wishes to increase the value of the currency,
then it may raise the level of interest rates in
the country. This will make the domestic
interest rates relatively higher than those
abroad and should attract financial
investment from abroad. In order to put
money into the country, the investors will
have to buy the countrys currency, thus
increasing the demand for it and so its
exchange rate.
In the same way, if the government wishes to
lower the value of the currency, then it may
lower the level of interest rates in the country.
This will make the domestic interest rates
relatively lower than those abroad and should
make financial investment abroad more
attractive. In order to invest abroad, the
investors will have to buy foreign currencies,
thus exchanging their own currency and
increasing the supply of it on the financial
exchange market. This should lower its
exchange rate.
Advantages and disadvantages of
fixed and floating exchange rates
Advantages of a fixed exchange rate
Exchange rates
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