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Macroeconomics: exchange rate determination

  • Floating exchange rate:  the equilibrium exchange rate and quantity determined by the foreign exchange market. Anything that shifts the demand or supply curve will change the equilibrium exchange rate.
  • Determinants of demand and supply for a currency:
    • Change in taste and preferences: say Chinese consumers start to prefer American made cars. We should expect the demand for US dollars to go up (in the market for dollars in China) and the supply for the Chinese Yuan to go up as well (in the market for Yuan in the U.S). This will lead to an appreciation of the U.S dollars and a depreciation of the Chinese Yuan.
    • Relative income level: consumers will be more likely to consume goods from countries with lower inflation rates.
    • Relative interest rate: the higher the interest rate (relative to another country), the higher the demand for a country's currency, as investors are interested in this opportunity. 
    • Speculation: expectation about a country's exchange rate among investors. For example, foreign investors believe that a country's currency will suddenly increase, they will demand more financial assets from this country in the short run in hopes of selling them in another currency at a later time.
    • The Canadian and U.S dollars are both floating currencies,  you can see that the exchange rate is solely determined by the foreign exchange market.
  • Fixed exchange rate: some governments choose to fix their currency to a certain level relative to another currency. This can be done in order to promote exports, via depreciating the country's currency. A country can also want to appreciate its currency if it relies on imported goods or wants to reduce inflation.
    •  Direct intervention: a government may directly intervene in the foreign exchange market by either selling or buying its own currency.
    • Indirect intervention: when the central bank decides to raise or lower the country's interest rate, it also affects its exchange rate. For example, the central bank decreases the money supply thereby raising the nominal interest rate, this will attract foreign investors which will appreciate the country's currency.
    • You can see that Qatar's currency is fixed to the dollar between 0.28 and 0.26 U.S cents.
Reference: Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 259-265.


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