Chapter 18 Summary

LO 18.1 The Basics of Exchange Rate

• The foreign exchange market determines the prices at which currencies exchange for each other, i.e., exchange rates.
• The rate at which a currency is exchanged with another currency is known as its exchange rate.
• Exchange rates are expressed in two ways, one being the reciprocal of the other. If the exchange value of £1 is USD1.50, the exchange value of the USD is £0.67.
• The interaction of demand for and supply of a currency determines the exchange rate.
• When supply is equal to demand in the foreign exchange market, the equilibrium exchange rate is determined.

LO 18.2 Currency Appreciation and Depreciation

• When the exchange rate for a currency rises, so that the currency exchanges for more of other currencies, we say that it is appreciating or “strengthening.” When the exchange rate for a currency falls, so that a currency trades for less of other currencies, we say that it is depreciating or “weakening.”
• Currency appreciation and depreciation will have a different meaning for different foreign exchange market participants.
• For a U.S. firm selling abroad, a stronger U.S. dollar is a curse. Conversely, for a foreign firm selling in the U.S. economy, a stronger dollar is a blessing.
• For a U.S. tourist abroad who is exchanging U.S. dollars for foreign currency as necessary, a stronger U.S. dollar is a benefit. For foreign visitors to the United States, the opposite pattern holds true.
• A stronger dollar injures the prospects of a U.S. financial investor who has already invested money in another country. However, a stronger U.S. dollar boosts the returns of a foreign investor putting money into a U.S. account.

LO 18.3 Different Exchange Rate Systems

• One of the decisions a country must make with respect to its currency is whether to fix its exchange value and try to maintain it for an extended period, or to allow its value to float or fluctuate according to market conditions.
• Broadly, we can distinguish three types of exchange rate regimes: a free-float, a managed-float, and a fixed exchange rate.
• In a free-floating exchange rate system, governments and central banks do not participate in the market for foreign exchange.
• In a managed float system, governments and central banks seek to increase or decrease their exchange rates by buying or selling their own currencies.
• In a fixed exchange rate regime, the government intervenes actively through the central bank to maintain the convertibility of their currency into other currencies at a fixed exchange rate.
• The central bank sets an official exchange rate and intervenes in the foreign exchange market to offset the effects of fluctuations in supply and demand and maintain a constant exchange rate.

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