Parkin Ch 26: The Exchange Rate and the Balance of
Payments
Part 1: The Foreign Exchange Market
- When we buy things from other countries we pay using the currency of that
country irrespective of the item being traded.
- Foreign money is referred to as foreign currency.
- We buy foreign currencies and foreigners buy SA rand in the foreign
exchange market.
Trading Currencies
- The currency of one country is exchanged for the currency of another in the
foreign exchange market.
- This market is made up of thousands of people – importers and exporters,
banks, international investors and speculators, international travellers and
specialist traders called foreign exchange brokers.
Exchange Rates
- The price at which one currency exchanges for another in the foreign
exchange market.
- Indirect method for quoting the exchange rate: x foreign currency for 1 unit
of local currency.
- Direct method: 1 unit of foreign currency for x units of local currency.
*Preferred method in SA as currency is often weaker.
- The exchange rate fluctuates. Sometimes it strengthens and sometimes it
weakens.
- Strengthening of the ex. Rate = appreciation.
- Weakening of the ex. Rate = depreciation.
An exchange rate is a price
- It is the price of one currency in terms of another.
- Determined (like all prices) in a market (the foreign exchange market).
- Foreign exchange market is a competitive market which entails demand and
supply determining the price.
- Special feature of the foreign exchange market: the Demand for one money
is the supply of another money.
- When people who are holding the money of some other country want to
exchange it for SA rand, they demand SA rand and supply that other
country’s money and vice versa.
- Hence, the factors that influence the demand for SA rand also influence the
supply of foreign currency.
Demand in the Foreign Exchange Market
- People buy SA rand in the foreign exchange market so that they can buy SA
produced g&s (SA exports).
- They also buy SA rand so that they can buy SA assets such as bonds, shares,
businesses and property or so that they can keep part of their money
holding in a SA rand bank account.
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- The quantity of SA rand demanded in the foreign exchange market is the
amount that traders plan to buy during a given time period at a given
exchange rate.
- Main factors influencing demand are:
1. The exchange rate (price)
2. World Demand for SA exports
3. Interest rates in SA and other countries
4. The expected future exchange rate.
The Law of Demand for Foreign Exchange
Other things remaining the same, the higher the exchange rate, the smaller is the
quantity of SA rand demanded in the foreign exchange market.
- The exchange rate influences the quantity of SA rand demanded for 2
reasons:
1. Exports Effect: the larger the value of SA exports, the larger is the
quantity of SA rand demanded in the foreign exchange market.
- but the value of SA exports depends on the prices of locally produced g&s
expressed in the currency of the foreign buyer.
- And these prices depend on the ex. Rate. The lower the ex. Rate, ceteris
paribus, the lower are the prices of SA produced g&s to foreigners and the
greater is the volume of SA exports.
2. Expected Profit Effect: the larger the expected profit from holding SA
rand, the greater is the quantity of SA rand demanded in the foreign
exchange market.
- But expected profit depends on the exchange rate.
- For a given expected future exchange rate, the lower the exchange rate
today, the larger is the expected profit from buying SA rand today and
holding them, so the greater that quantity of SA rand demanded in the
foreign ex. Market today.
Demand Curve for SA Rand
A change in the exchange rate, other things remaining the same, brings a change in
the quantity of SA rand demanded and a movement along the demand curve.
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