Chapter 11

Financial systems 3
foreign exchange
markets

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CHAPTER CONTENTS
LEARNING OUTCOMES ------------------------------------------------- 122
FOREIGN EXCHANGE RATES ------------------------------------------- 123

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FLOATING EXCHANGE RATES

124

FIXED EXCHANGE RATES

126

SINGLE CURRENCY ZONES

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LEARNING OUTCOMES
a) Explain the role of the foreign exchange market and the factors influencing
it, in setting exchange rates.

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Floating exchange rate

With a floating exchange rate the value of a currency is determined by demand and
supply.

Figure 1 below illustrates the equilibrium price of the dollar as being 50p. In other
words $1 will exchange for 50p.
o

$1 spent in the US acquires 50p worth of UK exports.

50p spent in the UK will purchase $1 of US exports.

In Figure 1 demand for the dollar increases as a result of changing tastes for US
products resulting in the demand curve shifting to the right. The price of a dollar in
sterling has now appreciated to 1!

Figure 1

Figure 2
$

$2

$1

50p

Demand and supply of $

Demand and supply of

The increased supply of sterling on the markets has in turn led to a depreciation
in value of the currency!

DISCUSSION 1

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Currency appreciation -

1
2

If a currency in value,
then...
The price of it's exports will..........
While price of it's imports will......

Currency depreciation -

1
2

If a currency in value,
then...
The price of it's exports will..........
While price of it's imports will......

Complete boxes 2 & 3 above to denote the impact of a domestic currency

export prices?

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Advantages and disadvantages

Advantages
o Continuous and automatic adjustment.

o Reduced need for government to hold foreign exchange reserves.

o Encourages efficient allocation of resources.

Disadvantages

o Expose firms to currency risks.

o Uncertainty regarding exchange rate movements may deter trade.

o Significant fluctuation may be politically damaging.

Fixed exchange rate

Fixed exchange rates have largely fallen out of fashion. The major difficulty is such
that at the time when rates are fixed against other currencies, they may have been
perfectly realistic. However changes in market pressures meant that the fixed rate
did not always correspond to the market rate!

Misalignments may be brought about by

Varying rates of inflation.

Different levels of economic growth.
Speculative attacks.

Advantages and disadvantages

Advantages
o Provides certainty which may encourage international trade.
o Imposes economic discipline on countries.
Disadvantages
o Loss of flexibility over domestic economic policy.
o Devaluation may be regarded as economic failure.

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Single currency zones

Membership of the Eurozone requires a state to give up its own monetary policy
and accept that of the European Central Bank. The rationale behind the single
currency is that it will lead to increased trade and price transparency.
The overriding argument against a single currency concerns the one size fits all
approach to economic policy.

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