2. The price of a nation’s currency in terms
of another currency.
An exchange rate thus has two
components, the domestic currency and
a foreign currency.
For example our domestic currency is the
Jamaican Dollars (JMD) and the Foreign
Currency can be United States Dollars
(USD) or Euros (EUR) just to name a few.
3. We will be exploring three types of
Exchange Rates which are:
1. Fixed Exchange Rate
2. Floating/Flexible Exchange Rate
3. Managed Float
4. This is where a Government maintains a
given exchange rate over a period of
This could be for a few months or even
In order to maintain the exchange rate
at the stated level government uses
fiscal and monetary policies to control
5. In a fixed exchange rate system the XR is
set by the government or central bank
at a particular rate.
E.g. BBD to US 2:1.
The forces of supply and demand do not
determine the rate. The central bank
holds reserves of US dollars and
intervenes in order to keep the
exchange rate pegged at that level
known as the Official Rate.
7. 1. The risk and uncertainty of trade and
promoting foreign direct investment (FDI) is
reduced thus making business and
investment planning possible.
2. Reduced Currency Speculation.
3. Creates a stability in knowing the
8. 1. Protecting the exchange rate requires
domestic economic policies to be
frequently adjusted. Monetary policy
focuses on keeping the rate stable.
2. Reserves are needed to protect the value.
3. An improvement in an economy’s
competiveness that results in lower prices
will not be fully passed on to export
customers if the exchange rate remains
4. Exchange rate may be undervalued or
9. A floating exchange rate regime is
where the rate of exchange is
determined purely by the demand and
supply of that currency on the foreign
10. The value of a currency is allowed to be
determined by the forces of demand
and supply on the foreign exchange
There is no government intervention.
11. Any change in supply or demand for a
currency will cause a depreciation or
appreciation in the exchange rate.
An increase in demand for the local
currency causes it to appreciate or rise.
However, if there is a greater demand
for the foreign currency the value of the
local currency falls or depreciates to the
12. Do not
13. An appreciation means an increase in the
value of a currency. It means a currency is
worth more in terms of foreign currency.
A rise or appreciation in the economy in the
country’s currency will mean that the price
of imports into the country will fall and the
price of the country’s exports will rise.
This is represented by a shift in the supply
curve to the left.
14. Do not
15. This could be caused by:
1. A decrease in the number of foreign
goods and services imported into the
2. A decrease in the number of the
economy’s investors who want to place
their funds in foreign economies.
16. 1. Exports more expensive. The foreign
price of Ja Exports will increase and US
will find Ja exports more expensive.
Therefore with a higher price, we would
expect to see a fall in the quantity of Ja
2. Imports are cheaper. Ja consumers will
find that JA$1 now buys a greater
quantity of US goods. Therefore, with
cheaper imports we would expect to
see an increase in the quantity of
17. 3. Lower (X-M) With lower exports, higher
demand and greater spending on imports,
we would expect a fall in domestic
Aggregate Demand (AD), causing lower
4. Lower inflation. An appreciation tends to
cause lower inflation because:
1. import prices are cheaper. The cost of
imported goods and raw materials will fall after
an appreciation, e.g. imported oil will
decrease, leading to cheaper petrol prices.
2. Lower AD leads to lower demand pull inflation.
3. With export prices being more expensive
manufacturers will have greater incentives to
cut costs to try and remain competitive.
18. A depreciation means a decrease in the
value of a currency. It means a currency is
worth less in terms of a foreign currency.
A fall or depreciation in the value of the
exchange rate will mean the opposite, that
is the price of imports into the country will
rise and the price of the country’s export
This is represented by a shift of the demand
curve to the left.
19. Do not
20. This could be caused by:
1. A reduction in the number of the
economy’s goods and services sold
2. A reduction in the number of
international investors who wish to place
their funds in the economy.
21. 1. Exports cheaper. A devaluation of the
exchange rate will make exports more
competitive and appear cheaper to
foreigners. This will increase demand for
2. Imports more expensive. A devaluation
means imports will become more
expensive. This will reduce demand for
3. Increased AD. Devaluation could cause
higher economic growth. Part of AD is (X-M)
therefore higher exports and lower imports
should increase AD (assuming demand is
relatively elastic). Higher AD is likely to
cause higher Real GDP and inflation.
22. 4. Inflation is likely to occur because:
Imports are more expensive causing cost
AD is increasing causing demand pull
With exports becoming cheaper
manufacturers may have less incentive to
cut costs and become more efficient.
Therefore over time, costs may increase.
5. Improvement in the current account. With
exports more competitive and imports more
expensive, we should see higher exports
and lower imports, which will reduce the
current account deficit.
23. market determined, so it is more efficient
no need for reserves to intervene
exchange rate would reflect its true
absorbs economic shocks better
freedom of government to pursue
Automatic BOP adjustment, less
likelihood of a BOP crisis
24. large depreciation may occur
instability of exchange has a negative
impact on domestic economy
terms of trade may decline with fall in
Uncertainty of currency
Speculation of currency
reduced investment as this would be too
25. The Fixed exchange rate is the rate which is
officially fixed in terms of gold or any other
currency by the government. It does not
change with change in demand and
supply of foreign currency.
As against it, flexible exchange rate is the
rate which, like price of a commodity, is
determined by forces of demand and
supply in the foreign exchange market. It
changes according to change in demand
and supply of foreign currency. There is no
26. This is where the currency is broadly
managed by the forces of demand and
supply but the government takes action
to influence the rate of change in the
27. The Central Bank seeks to stabilize the
exchange rate within a predetermined
range for a given period of time, but
DOES NOT FIX IT at any particular level.
This allows for policy makers the benefit
of planning with some degree of
certainty, for the macroeconomic affairs
of a country.
Central bank intervenes to smoothen out
ups and downs in the exchange rate of
home currency to its own advantage.
29. The managed float attempts to combine
the advantages of both the fixed and
flexible exchange rate systems,
depending on the degree of instability.
The less instability, the less intervention is
necessary by central banks and they
can pursue quasi-independent domestic
monetary policies to stabilize their own
30. The greater the instability, the more
intervention is necessary by central
banks and the less free they are to
pursue independent domestic monetary
policies because they are frequently
required to use their money supplies to
calm disturbances in the foreign
31. The big problem with a managed float
comes in determining the timing and
magnitude of the instability and the
necessary intervention. Does a one day
drop (rise) in a currency warrant
intervention? A week? A month? A year?
Five years? Is a 1% drop (rise) in a
currency's exchange rate destabilizing?
A 2% change? A 5% change? A 10%
32. If the central banks are too quick to
respond or if the amount of intervention
is inappropriate, their actions may be
further destabilizing. This increased
instability has a tendency to dampen
international flows and contract world
trade. If they wait too long, permanent
damage may be done to some
countries' trade and investment
33. Changes in the exchange rate will cause
an Appreciation or Depreciation in the
local currency as explained earlier.
If the currency is devalued then:
1. The price effect – goods become cheaper
and imports become more expensive. The
devaluation worsens the BOP.
2. the volume effect – cheaper exports mean
that more will be sold and less imports will
be bought thus improving the BOP.
34. The devaluation worsens the current
account balance initially, and then it
improves. Reasons being:
Time lag in consumer response –
people may still want the expensive
good. Consumers may be concerned
about the quality and quantity of the
local good and may continue buying
the foreign goods in the short-run.
Time lag in producer response –
producers may take a long time to
adapt to say changing their plant size
to accommodate the increase in