Exchange Rate

Course: International Economics

Teacher: Snjeana Brki, Ph.D.
SCHOOL OF ECONOMICS AND BUSINESS
UNIVERSITY OF SARAJEVO
Objectives
After the presentation students will be able:
to define and to calculate exchange rate;
to understand the role of exchange rates in international economics;


Content
1. Introduction
2. Definition and Functions of Exchange Rate
2.1. Quotation
2.2. Cross Exchange Rates
2.3. Functions of Exchange Rate
3. Determination of Exchange Rate
4. Conclusion
5. Literature

1. Introduction
For their interdependence, the balance of payments and the exchange
rates cannot be analysed separately.
The exchange rate depends on the balance of payments and its
accounts.
The exhange rate policy influences the balance of payments policy,
because changes in the exchange rate lead to changes in the balance of
payments accounts.
Changes in the exchange rate affect producers, importers and exporters,
investors, consumers, tourists and others.
2. Definition and Functions of Exchange Rate
Definition:

Exchange rate is the price of one countrys currency in term of another
countrys currency.

Foreign exchange rate is the price of a foreign currency in term of the
domestic currency.

2. Definition and Functions of Exchange Rate

Foreign exhange rate shows how many units of the domestic currency
should be paid for an unit of a foreign currency:
if the foreign exchange rate increases, we have to pay more units of
the domestic currency for an unit of the given foreign currency (the
domestic currency becomes weaker it depreciates);
if the foreign exchange rate decreases, we have to pay fewer units
of the domestic currency for an unit of the given foreign currency
(the domestic currency becomes stronger it appreciates);
2. Definition and Functions of Exchange Rate
2.1. Quotation
The exchange rate in the foreign exchange market of a given country can be
quoted in two ways:

Direct quotation

Indirect quotation
2. Definition and Functions of Exchange Rate
2.1. Quotation
Direct quotation - the price of a foreign currency in terms of the domestic
currency:
1 EUR = 2 KM (1 EUR = 1,95583 BAM)

Indirect quotation - the price of the domestic currency in terms of a foreign
currency:
1 KM = 0,50 EUR (1 BAM = 0,51129 EUR)

Exchange rate with indirect quotation is the reciprocal value of exchange
rate with direct quotation:
ER = 1 / ER
ER = 1 / (2 BAM/EUR) = 0,50 EUR/BAM


2. Definition and Functions of Exchange Rate
2.1. Quotation
Functions of money:
medium of exchange;
unit of account (measure of value);
store of value;

In the domestic foreign exchange market:
a foreign currency is a good (although a specific one) and has its
price the exchange rate;
the domestic currency is not a good than a measure of value and
serves to express prices of other goods.

2. Definition and Functions of Exchange Rate
2.1. Quotation
a currency that is being bought or sold is a reference currency; in direct
quotation - the second currency in a currency pair;
a currency in which transaction is denominated is base or accounting
currency; the first currency quoted in a currency pair on forex;

ER(X/Y)
ER(accounting currency/reference currency)
ER(domestic currency/foreign currency)

(the price of currency Y is expressed in a number of units of currency X;
therefore currency Y is a traded good which price is denominated in
currency X)

2. Definition and Functions of Exchange Rate
2.2. Cross Exchange Rate
Cross exchange rate
Numerical Example:
1 USD = 1,450912 BAM 1,450912 BAM/USD
1 EUR = 1,955830 BAM 1,955830 BAM/EUR
Calculate exchange rate of EUR how many dollars for one euro (USD/EUR)?
value of EUR in BAM / value of USD in BAM
(new reference valute in BAM / new accounting value in BAM)
1,955830 BAM/EUR / 1,450912 BAM/USD
1,955830 / 1,450912 x BAM/EUR x USD/BAM = 1,3480 USD/EUR

2. Definition and Functions of Exchange Rate
2.3. Functions
Exchange rates play a central role in international trade, because they
enable us to compare the prices of goods and services produced in
different countries and conversion of value.
Exchange rate is an important factor for investment decision making
process.
Exchange rate serves as an instrument for adjustment.
3. Determination of Exchange Rate
Exchange rates are determinated in the foreign exchange market by
market forces - both supply and demand conditions.

The real (equilibrium) exchange rate is the exchange rate that equalizes
supply and demand in the foreign exchange market; it is the rate that
clears the market.

3. Determination of Exchange Rate
3. Determination of Exchange Rate
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Iznos inozemne valute
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KM /
Potranja
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E
E the equilibrium exchange rate;
3. Determination of Exchange Rate
Supply of foreign exchange:
supply of foreign exchange refers to the amount of foreign exchange
that will be offered to the market at various exchange rates, all other
factors held constant.
Supply of foreign exchange results from credit (active) transactions of
the balance of payments, such as:
export of goods,
export of services,
unilateral transfers from abroad,
income from investment,
inflow of foreign capital;
supply schedule has a positive slope, because supply increases when the
exchange rate increases;
3. Determination of Exchange Rate
Demand for foreign exchange:
Demand for foreign exchange is derived from debit (passive)
transactions of the balance of payments, such as:
import of goods,
import of services,
unilateral transfers from a country,
income of foreign investment,
outflow of capital;
demand schedule has a negative (declining) slope, because it varies
inversely with the exchange rate;

3. Determination of Exchange Rate
Two components:
par value relation of the domestic currency to some conventional
common denominator (gold, dollar or SDR); the external value of a
currency;
purchasing power parity - value of a currency expressed in the quantity
of goods that could be buy for an unit of the currency; internal value of a
currency;

3. Determination of Exchange Rate
Terms depreciation and devaluation as well as appreciation and
revaluation are not synonyms:
depreciation a real decrease in a currency value; decreasing of
its internal value (purchasing power);
appreciation a real increase in a currency value; increasing of
its internal value (purchasing power);
devaluation an official reduction of a currency value
(reduction of the external value - par value) by a formal act of
monetary authorities;
revaluation an official increasing of a currency value
(increasing of the external value par value) by a formal act of
monetary authorities;
3. Determination of Exchange Rate

depreciation/devaluation weakening of domestic currency (increase
of exchange rate) domestic goods cheaper for foreigners increase
in export

appreciation/revaluation strengthening of domestic currency (decline
of exchange rate) domestic goods more expensive for foreigners
increase in import
3. Determination of Exchange Rate
Quotation Change in
exchange rate
Apreciation/
Revaluation
Depreciation/
Devaluation
Direct
quotation
ER foreign
currency
domestic
currency
ER domestic
currency
foreign
currency
Indirect
quotation
1/ER domestic
currency
foreign
currency
1/ER foreign
currency
domestic
currency
3. Determination of Exchange Rate
the real (equilibrium) exchange rate stimulates a rational allocation of
resources and shows level of competitiveness of a country;
overvalued currency:
official value (par value) > purchasing power
makes import cheaper, stimulates import and consumption; works
inflatory;
method of correction devaluation;
undervalued currency:
official value (par value) < purchasing power
makes domestic goods cheaper for foreigners thus stimulates export
and allocation of resources towards export industries;
method of correction revaluation;
4. Conclusion
A prominent interdependence exists between balance of payments
accounts and exchange rate.
Exchange rate is a price of one currency (a reference currency) in terms
of another currency (a base or accounting currency).
Exchange rates could be quoted directly or indirectly.
Exchange rates are determinated in the foreign exchange market by
supply and demand conditions.
Depreciation/devaluation means decrease in a currency value, and
apreciation/revaluation means increase in a currency value.

http://www.youtube.com/watch?v=xwtgByffoUw
5. Literature
Carbaugh Robert, International Economics, Eighth Edition, South-Western,
2002
Kovaevi Radovan, Meunarodne finansije, Ekonomski fakultet Univerziteta u
Beogradu, Beograd, 2011.
Krugman Paul, Maurice Obstfeld, International Economics: Theory and Policy,
8th Edition, Prevod, MATE, Zagreb, 2009.
Salvatore Dominick, International Economics, Ninth Edition, Wiley, 2007
Stojanov Dragoljub, Meunarodne finansije u globalnoj ekonomiji, IV
izmijenjeno i dopunjeno izdanje, Ekonomski fakultet u Sarajevu, Sarajevo, 2000.
Literature, Lessons for Exam and Essay Questions
Literature:
Paul Krugman, Maurice Obstfeld, International Economics Theory
and Policy, Seventh Edition;
Slides;

Lessons for Exam:
pp. 306-334.; slides;

Essay Questions:
Exchange Rate and Foreign Exchange Market
Exchange Rate Regimes

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