What this lesson teaches
I can define floating rates, appreciation and depreciation, and explain how demand and supply set an exchange rate.
Syllabus K343, 6.3.3. Determination of foreign exchange rate in foreign exchange market: definitions of floating exchange rate, appreciation and depreciation; the demand for and supply of a currency; the determination of the equilibrium foreign exchange rate; causes of foreign exchange rate fluctuations, changes in demand for exports and imports, changes in the interest rate, speculation
Make a guess
Many more foreign tourists visit Singapore this year. What happens to the value of the Singapore dollar?
- Nothing, because tourists do not use the currency market.
- It falls, because tourists bring in foreign money.
- It tends to rise as tourists buy S$.
Show the answer
It tends to rise as tourists buy S$.
Tourists must change their money into S$ to spend here. Demand for the S$ rises, so it appreciates.
Exchange rates change when demand for exports or imports changes, when interest rates change, or when speculators act.
Changes in demand for exports and imports: if foreigners buy more of a country's exports, they need more of its currency. Demand for the currency rises and it appreciates. If residents buy more imports, they sell more of their currency, so supply rises and it depreciates.
Changes in interest rates: if a country's interest rates rise relative to others, saving there becomes more attractive. Foreign savers buy its currency to deposit money in its banks, so the currency appreciates.
Speculation: if speculators expect a currency to rise, they buy it now, which increases demand and causes it to rise. Expectations can become self-fulfilling.
Government intervention, such as a central bank buying its own currency, can also change the rate.
Sort these
Sort each event by what it does to the value of the Singapore dollar.
Groups: The S$ tends to appreciate, The S$ tends to depreciate.
- Speculators expect the S$ to fall and sell it.
- Foreign buyers order many more Singapore-made chips.
- Singapore residents buy many more imported cars.
- Singapore firms build many factories abroad.
- Interest rates in Singapore rise compared with other countries.
- Speculators expect the S$ to rise and buy it now.
Show the answer
The S$ tends to appreciate
- Foreign buyers order many more Singapore-made chips. They need S$ to pay Singapore firms, so demand for the S$ rises.
- Interest rates in Singapore rise compared with other countries. Foreign savers buy S$ to earn the higher return.
- Speculators expect the S$ to rise and buy it now. Their buying raises demand for the S$, which pushes its value up.
The S$ tends to depreciate
- Speculators expect the S$ to fall and sell it. Selling raises the supply of S$, which pushes its value down.
- Singapore residents buy many more imported cars. They sell S$ to buy foreign currency, which raises the supply of S$.
- Singapore firms build many factories abroad. Paying for foreign investment means selling S$ for other currencies.
- Exports rise
- Demand for the currency rises; appreciation.
- Imports rise
- Supply of the currency rises; depreciation.
- Higher interest rates
- Attract foreign savings; appreciation.
- Speculation
- Expected rises can cause actual rises.
Worked example: Explaining an appreciation
Suppose world demand for Singapore's pharmaceuticals rises strongly.
- Foreign buyers need S$ to pay Singapore firms.
- Demand for S$ rises: the demand curve shifts right from D0 to D1.
- At the old rate there is excess demand for S$, so its price rises.
- The S$ appreciates from ER0 to ER1.
Watch out for this
A rise in a country's interest rate makes its currency depreciate.
Higher interest rates attract foreign savings, which increases demand for the currency, so it usually appreciates.
Check your understanding
Foreign demand for a country's exports rises sharply. What happens to its currency?
- It appreciates, as buyers need it to pay.
- It depreciates, as exporters sell it abroad.
- It stays the same, as trade does not move it.
Show the answer
It appreciates, as buyers need it to pay.
Right. Foreign buyers must buy the currency to pay for its exports, so demand for it rises.
Check your understanding
Interest rates in Country A rise while rates elsewhere stay the same. What is likely to happen to Country A's currency?
- It appreciates as savers buy it
- It depreciates as savers sell it
- It depreciates because loans become dearer
- It stays the same, because trade is unchanged
Show the answer
It appreciates as savers buy it
Right. Higher returns attract foreign savers, who must buy Country A's currency.