An exchange rate is the price of one currency expressed in terms of another currency. As economic conditions change, exchange rates may become substantially volatile. A decrease in a currency’s value relative to another currency is known as depreciation or devaluation. Likewise, an increase in a currency’s value is known as appreciation or revaluation. MNCs frequently measure a percentage change in the exchange rate between two specific points in time; that is, the current exchange rate and the forecasted exchange rate one year ahead.
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Let us assume that a subsidiary purchases its raw materials from country A and sells its finished products to country B. Thus, both exports and imports are denominated in foreign currencies. In this case, exchange rate fluctuations affect the level of both revenues and costs measured in terms of the domestic currency. An appreciation in the revenue currency (country B’s currency) raises profits, assuming that costs remain constant. In contrast, an appreciation in the cost currency (country A’s currency) reduces profits after taxes unless selling prices are adjusted to reflect the increase in costs.
If prices in the local currencies are increased by the same percentage as the increase in the cost of imports, the effect of exchange rate fluctuations on profits is identical with the effect of a comparable local inflation rate (Kim & Kim, 2006).
Shifts in the Currency Demand and Supply Curves (Sloman, 2006)
A Fall In Domestic Interest Rates
UK rates would now be less competitive for savers and other depositors. More UK residents would be likely to deposit their money abroad (the supply of sterling would rise) and fewer people abroad would deposit their money in the UK (the demand for sterling would fall).
Higher Inflation In The Domestic Economy Than Abroad
UK exports will become less competitive. The demand for sterling will fall. At the same time, imports will become relatively cheaper for UK consumers. The supply of sterling will rise.
A Rise In Domestic Incomes Relative To Incomes Abroad
Relative Investment Prospects Improving Abroad
If investment prospects become brighter abroad than in the UK, perhaps because of better incentives abroad or because of worries about an impending recession in the UK, again the demand for sterling will fall and the supply of sterling will rise.
Speculation That The Exchange Rate Will Fall
If businesses involved in importing and exporting and also banks and other foreign exchange dealers think that the exchange rate is about to fall they will sell pounds now before the rate does fall. The supply of sterling will thus rise.
Longer-Term Changes In International Trading Patterns
Over time the pattern of imports and exports is likely to change as consumer tastes change, the nature and quality of goods change and the costs of production change. If as a result, UK goods become less competitive than German or Japanese goods, the demand for sterling will fall and the supply will rise. These shifts of course are gradual taking place over many years.
Managing The Exchange Rate
The government may be unwilling to let the country’s currency float freely. Frequent shifts in the demand and supply curves would cause frequent changes in the exchange rate. This in turn might cause uncertainty for businesses, which might curtail their trade and investment. The government may thus ask the central bank (the Bank of England in the case of the UK) to intervene in the foreign exchange market.
Reducing Short-Term Fluctuations
The Bank of England can sell gold and foreign currencies from the reserves to buy pounds. This will shift the demand for sterling back to the right.
Borrowing From Abroad
In extreme circumstances, the government could negotiate a foreign currency loan from other countries or from and international agency such as the International Monetary Fund. The Bank of England can then use these moneys to buy pounds on the foreign exchange market, thus again shifting the demand for sterling back to the right.
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Raising Interest Rates
If the Bank of England raises interest rates, it will encourage people to deposit money in the UK and encourage UK residents to keep their money in the country. The demand for sterling will increase and the supply of sterling will decrease.
Maintaining A Fixed Rate Of Exchange Over The Longer Term
This is where the government deliberately curtails aggregate demand by either fiscal policy or monetary policy or both. Deflationary fiscal policy involves raising taxes and/or reducing government expenditure. Deflationary monetary policy involves reducing the supply of money and raising interest rates. In this case the use of higher interest rates to reduce borrowing and hence dampen aggregate demand.
This is where the government attempts to increase the long-term competitiveness of UK goods by encouraging reductions in the costs of production and/or improvements in the quality of UK goods. For example, the government may attempt to improve the quantity and quality of training and research and development.
Controls On Imports And Or Foreign Exchange Dealing
This is where the government restricts the outflow of money, either by restricting people’s access to foreign exchange or by the use of tariffs and quotas. Tariffs are another word for customs duties. As taxes on imports, they raise their price and hence reduce their consumption. Quotas are quantitative restrictions on various imports.