Economics 9708
Lower Six
Exchange Rates
An exchange rate refers to the value of one currency in relation to another. It is the price of one
particular currency expressed in terms of another.
For example, the price of US$1 may be 50 Zambian Kwacha. This would mean that a 5000-
Kwacha product would sell in the US for US$100. A rise in Zambia’s foreign exchange rate
against the US dollar would increase the price of Zambia’s exports in terms of US dollars and
would lower the price of Zambia’s imports in terms of Kwacha. For example, the value of the
Kwacha might rise to US$1 equals 40 kwacha so that a US dollar may be purchased with fewer
kwacha. Now a 5000- kwacha product would sell in the US for US$125. A US $20 import that
would have initially sold in Zambia for 1000 kwacha, will now sell in Zambia for 800 kwacha.
How a floating exchange rate is determined
A floating exchange rate is one that allows the value of a currency to be determined by the forces
of demand and supply, just like the price of anything else in a free market. There are various
reasons why currency traders will buy the domestic currency. These include enabling their
customers to:
purchase goods and services from the country
invest in the country
speculate on making a profit if the value of the currency should rise in the future.
Financial institutions also speculate on future currency movements on their own behalf.
Depreciation and appreciation of a floating exchange rate
A fall in the value of a currency caused by market forces is known as depreciation. Such a fall
will cause a reduction in export prices in terms of foreign currencies and a rise in import prices in
terms of the domestic currency. An increase in the supply of a currency will result in a fall in its
value.
A rise in the value of the currency, caused by an increase in demand and/or a decrease in supply,
is known as an appreciation. This will make exports more expensive in terms of foreign
currencies, and imports cheaper in terms of the domestic currency.
The causes of changes in a floating exchange rate
Changes in a country’s floating exchange rate can be caused by a number of factors, including:
the demand for the country’s exports from other countries
the demand for imports into the country
inflation rates in different countries affecting international competitiveness
perceptions of quality/reliability in relation to both exports and imports
changes in interest rates in different countries, affecting movements of ‘hot money’
changes in average costs of production in various countries, affecting the relative level of
competitiveness
differences in the changes in relative technology between countries
trends in tourism
changes in levels of confidence in the economies of different countries and/or the
possibility of speculation
changes in a country’s current account balance
changes in the economic growth rates of different countries
The impact of exchange rate changes on the domestic economy
I. The impact of a depreciation on the domestic economy’s national income and real
output
A fall in the value of the exchange rate will make exports cheaper, in terms of foreign
currencies, and imports more expensive, in terms of the domestic currency. This will
result in a rise in net exports which will in turn increase aggregate demand.
II. The impact of a depreciation on the domestic price level
The higher aggregate demand that occurs because of a rise in net exports may give rise to
inflationary pressure.
III. The impact of depreciation on the domestic economy
If a depreciation does result in higher aggregate demand, firms producing for both the
domestic economy and the external economy will be likely to take on more workers to
expand their output. This may cause a decrease in cyclical unemployment.
IV. The impact of an appreciation on the domestic economy’s national income and real
output
An appreciation (a rise in the exchange rate) will make exports more expensive in terms
of foreign currencies, and imports cheaper in terms of the domestic currency. This is
likely to result in a fall in demand for domestic products. This could result in a slowdown
in economic growth or possibly even a recession. With lower real output, incomes are
likely to fall.
V. The impact of an appreciation on domestic inflation
An appreciation may cause a reduction in inflationary pressure if the economy is
operating close to or at maximum capacity.
In the absence of a rise in the exchange rate, aggregate demand might increase to AD1
causing the price level to rise to P1. A rise in the exchange rate may reduce the growth of
aggregate demand to AD2 and so the inflation rate would be lower than would be the
case if the exchange rate had remained unchanged.
VI. The impact of an appreciation on unemployment
An appreciation may increase unemployment. If aggregate demand decreases, firms may
not replace workers who retire and may make some workers redundant.
