FOREIGN EXCHANGE RATE

Exchange Rate
Definition:
The price of one country's currency expressed in
another country's currency. In other words, the rate at
which one currency can be exchanged for another. For
example, the higher the exchange rate for one U.S. dollar
in terms of one Pak rupee, the lower the relative value of
the rupee.
 Types of Exchange Rates
Nominal Exchange Rate
The rate at which two currencies can be traded is the
nominal exchange rate between the two currencies. For
example, if the nominal exchange rate between the U.S.
dollar and the Pak rupee is 100 rupee per dollar, a dollar
can buy 100 rupees (ignoring transaction fees) in the
foreign exchange market, which is the market for
international currencies. The nominal exchange rate
often is simply called exchange rate.
 Types of Exchange Rates
Real Exchange Rate
The price of domestic goods relative to foreign goods –
equivalently, the number of foreign goods someone gets
in exchange for one domestic good – is called the real
exchange rate. In general, the real exchange rate is
related to the nominal exchange rate and to prices in
both countries.
 Types of Exchange Rates
Real Exchange Rate
To write this relation we use the following symbols:
enom = the nominal exchange rate
(100 rupees per dollar);
PFor = the price of foreign goods, measured in the
foreign currency
(1000 rupees per Pakistani beef burger);
P = the price of domestic goods, measured in
the domestic currency
(2 dollars per U.S. beef burger)
 Types of Exchange Rates
Real Exchange Rate
The real exchange rate, e, is the number of foreign goods (Pakistani beef
burgers) that can be obtained in exchange for one unit of the domestic good
(U.S. beef burgers). The general formula for the real exchange rate is

𝑃𝑓𝑜𝑟
𝑒 = 𝑒𝑛𝑜𝑚
𝑃𝑑𝑜𝑚

100 $2
𝑒=
1 𝑅𝑠. 100

e = 0.2 Pakistan beef burgers per U.S. beef burger

 Exchange Rate System
Flexible or Floating-Exchange-Rate System
In a flexible or floating-exchange-rate system,
exchange rates are not officially fixed but are
determined by conditions of supply and demand in
the foreign exchange market. Under a flexible-
exchange-rate system, exchange rate move
continuously and respond quickly to any economic
or political news that might influence the supplies
and demands for various currencies.
 Exchange Rate System
Managed-Float System
Under the managed-float system the central bank of a
country intervenes in foreign exchange market to
prevent large fluctuations in exchange rate. This system
is not completely flexible-exchange-rate system or
floating-exchange-rate system but is managed by the
Central Bank.
 Exchange Rate System
Fixed-Exchange-Rate System
The values of currencies have not always been
determined by a flexible-exchange-rate system. In the
past, some type of fixed-exchange-rate system under
which exchange rates were set at officially determined
levels, often operated. Usually, these official rates
maintained by commitment of nation’s central banks to
buy and sell their own currencies at the fixed exchange
rate.
The supply of and demand for the
dollar
How Exchange Rates Are Determined
• What causes changes in the exchange rate?
– Supplying dollars means offering dollars in exchange
for the foreign currency
– The supply curve slopes upward, because if people can
get more units of foreign currency for a dollar, they’ll
supply more dollars
– Demanding dollars means wanting to buy dollars in
exchange for the foreign currency
– The demand curve slopes downward, because if people
need to give up a greater amount of foreign currency to
obtain one dollar, they’ll demand fewer dollars
How Exchange Rates Are Determined
• Why do people demand or supply dollars?
– People need dollars for two reasons:
• To be able to buy U.S. goods and services (U.S.exports)
• To be able to buy U.S. real and financial assets (U.S.
financial inflows)
– These transactions are the two main categories in the
balance of payments accounts: the current account and
the capital and financial account
How Exchange Rates Are Determined
• Why do people demand or supply dollars?
– People want to sell dollars for two reasons:
• To be able to buy foreign goods and services (U.S.
imports)
• To be able to buy foreign real and financial assets (U.S.
financial outflows)
How Exchange Rates Are Determined
• Factors that increase demand for U.S. exports and assets
will increase demand for dollars, shifting the demand
curve to the right and increasing the nominal exchange
rate
– For example, an increase in the quality of U.S. goods
relative to foreign goods will lead to an appreciation of
the dollar
 THE EFFECT OF INCREASED EXPORT
QUALITY ON THE VALUE OF THE DOLLAR