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
The rate moves from S$1 = US$0.75 to S$1 = US$0.80. What has happened to the Singapore dollar?
- It has appreciated against the US dollar.
- It has depreciated, because the number went up.
- Nothing, because 5 cents is too small to count.
Show the answer
It has appreciated against the US dollar.
Each S$ now buys more US dollars, so the S$ has risen in value.
In a floating system, the exchange rate is set by the demand for and supply of the currency.
A floating exchange rate is one set by market forces: the demand for and supply of the currency, without the government fixing it.
Demand for a currency comes from foreigners who want to buy the country's exports, invest in it, or save in its banks. Supply comes from the country's residents selling their currency to buy imports or invest abroad.
The equilibrium exchange rate is where demand for the currency equals supply. Draw it like any demand and supply diagram, with the price of the currency on the vertical axis.
An appreciation is a rise in the value of a currency: it buys more foreign currency. A depreciation is a fall in its value: it buys less.
- Floating exchange rate
- Set by demand for and supply of the currency.
- Appreciation
- Rise in a currency's value.
- Depreciation
- Fall in a currency's value.
Worked example: Reading appreciation and depreciation
Suppose the rate moves from S$1 = US$0.75 to S$1 = US$0.80.
- Each S$ now buys more US dollars.
- So the S$ has appreciated against the US dollar.
- Seen the other way, the US dollar has depreciated against the S$.
- If the rate had moved to S$1 = US$0.70, the S$ would have depreciated.
Watch out for this
The supply of a currency comes from the government printing money.
In the foreign exchange market, the supply of a currency comes from people and firms selling it to buy other currencies, such as importers.
Check your understanding
Tourists from China flock to Singapore and change yuan into Singapore dollars. Under a floating rate, what happens to the S$?
- Demand for S$ rises, so the S$ appreciates.
- The S$ holds steady until MAS buys more of it.
- Supply of S$ rises, so the S$ depreciates.
Show the answer
Demand for S$ rises, so the S$ appreciates.
Right. Tourists buy S$ to spend here, so demand for the currency rises and its value goes up.
Check your understanding
Which change increases the demand for Singapore dollars on the foreign exchange market?
- Singapore firms buy more imported parts
- Singaporeans buy more shares in foreign firms
- Singaporeans take more holidays abroad
- Foreign firms buy more Singapore exports
Show the answer
Foreign firms buy more Singapore exports
Right. To pay for Singapore goods, foreign buyers need Singapore dollars.