The Exchange Rate
Exchange rate (E)
Countries trade due to uneven distribution of factors of production
Foreign currency is the money of other countries regardless of form
An exchange rate is the price at which one currency exchanges for another in the foreign
exchange market
Openness of the economy is the extent of a country’s involvement in international trade
and finance
Quotation of Exchange rate
Direct Method Indirect Method
How much of the local currency (Rand) has to How much of the foreign currency (Dollar)
be exchanged for 1 unit of foreign currency has to be exchanged for 1 unit of local
(Dollar) currency (Rand)
R10=$1 $0.10 =R1
Appreciation: An increase in the value or price of one currency in terms of another and this
implies depreciation of the other currency
Depreciation: A decrease in the value of one currency in terms of another and this implies
appreciation of the other currency
Exchange rate determination
1. Fixed regime
2. Flexible or Floating Regime
3. In between there are many possible intermediate cases (crawling peg):
- Adjustable peg: Monetary authorities attempt to maintain par values for their E but
explicitly recognise that circumstances may arise in which they will change the par value.
- Managed float: Monetary authorities seek to have a stabilising influence on the E but
without trying to fix it at some publicly announced par value
– And a number of other similar regimes that fall into this intermediate exchange rate
regimes category e.g. crawling peg, joint float, and exchange rate band
Understanding the exchange rate
Demand for currency (Rands): US residents who want to buy goods and services from or
invest in assets in SA. Demand for rands is downward sloping which means the lower price
of rand the more rands will be demanded.
Supply of Currency (Rands): SA residents who want to buy goods and services from US or
invest in assets in US. Supply for rand (or dollar) is upward sloping or has a positive slope
,Appreciation of the $ = depreciation of the R$1 will buy more RandsR1 will buy fewer
dollars
Depreciation of the $ = appreciation of the R $1 will buy less Rands R1 will buy more
dollars
Changes in flexible Exchange rates
Changes in demand or supply in the foreign exchange market
Appreciation of the Rand (Depreciation of the Dollar)
,Caused by an increase in the demand for Rands (increase in supply of dollars) or a decrease
in the supply of Rands (decrease in demand of dollars). Anything that shifts the demand
curve to the right (Increase) or the supply curve to the left (Decrease)
Depreciation of the Rand (Appreciation of the Dollar)
Caused by a decrease in the demand for Rands (decrease in supply for dollars) or an
increase in the supply of Rands (increase in demand for dollars). Anything that shifts the
demand curve to the left or the supply curve to the right.
Factors that shift demand and supply
Import from US
Increase in demand for imported goods from US due to increase in incomes in SA
This causes DD for dollars to shift to the right
The exchange rate to increase
This implies appreciation of dollar and depreciation of the rand
Interest rate in SA
Higher interest rate in SA relative to US
Attract American investors to invest in SA
Increase the supply of dollars
Depreciation of dollar and appreciation of rand
Speculation
If the dollar is expected to decrease
Decrease in demand for dollars
Exchange rate falls
Depreciation of the dollar and appreciation of rand
Inflation
higher inflation in SA
US goods are relatively cheaper so increase in demand for US goods
Increase in demand for dollars
Appreciation of dollar and depreciation of rand
, When SA currency appreciates:
Demand for SA products and demand for SA Rands, Qd decreases
When SA currency appreciates:
Demand for US products Demand for US dollars increases
Example: What happens to the SA goods when the rand appreciates from E0 to E1?
e.g. To buy R100 barrels of SA wine:
E=$/R Cost of Wine (R) Cost of Wine ($)
E0 E= $0.08/R R100 8$
E1 E= $0.10/R R100 10$
SA wine has become relatively more expensive.
Example: What happens to the US goods market when the rand appreciates from E0 to E1?
e.g. To buy $100 pair of Levi Jeans:
E=$/R E=R/$ $ price R Price
E0 E= $0.08/R R12/$ $100 R1200
E1 E=$0.1/R R10/$ $100 R1000
US products have become relatively cheaper. Imports of US goods increase
What drives exchange rate expectations
Exchange rate expectations are driven by expectations about the fundamental
influences on the exchange rate, namely:
– Exports: world demand for SA exports
– Imports: SA demand for imports
– Interest rates: SA interest rate relative to foreign
Expectations about these variables change the exchange rate through their influence on
the expected exchange rate and the effect is instant.
E.g. an expectation that the SA Reserve Bank will increase interest rate in the near future
will lead to an immediate increased demand for rands by traders and speculators – to
capitalise on higher rand price when interest rate is adjusted upwards.
Arbitrage and interest rate parity and purchasing power parity
Interest rate parity: returns on investment are the same across countries, taking e-rates into
account
Scenario 1: interest rate in US is 3% and in SA it is 8% but dollar expected to appreciate
against the rand.
Exchange rate (E)
Countries trade due to uneven distribution of factors of production
Foreign currency is the money of other countries regardless of form
An exchange rate is the price at which one currency exchanges for another in the foreign
exchange market
Openness of the economy is the extent of a country’s involvement in international trade
and finance
Quotation of Exchange rate
Direct Method Indirect Method
How much of the local currency (Rand) has to How much of the foreign currency (Dollar)
be exchanged for 1 unit of foreign currency has to be exchanged for 1 unit of local
(Dollar) currency (Rand)
R10=$1 $0.10 =R1
Appreciation: An increase in the value or price of one currency in terms of another and this
implies depreciation of the other currency
Depreciation: A decrease in the value of one currency in terms of another and this implies
appreciation of the other currency
Exchange rate determination
1. Fixed regime
2. Flexible or Floating Regime
3. In between there are many possible intermediate cases (crawling peg):
- Adjustable peg: Monetary authorities attempt to maintain par values for their E but
explicitly recognise that circumstances may arise in which they will change the par value.
- Managed float: Monetary authorities seek to have a stabilising influence on the E but
without trying to fix it at some publicly announced par value
– And a number of other similar regimes that fall into this intermediate exchange rate
regimes category e.g. crawling peg, joint float, and exchange rate band
Understanding the exchange rate
Demand for currency (Rands): US residents who want to buy goods and services from or
invest in assets in SA. Demand for rands is downward sloping which means the lower price
of rand the more rands will be demanded.
Supply of Currency (Rands): SA residents who want to buy goods and services from US or
invest in assets in US. Supply for rand (or dollar) is upward sloping or has a positive slope
,Appreciation of the $ = depreciation of the R$1 will buy more RandsR1 will buy fewer
dollars
Depreciation of the $ = appreciation of the R $1 will buy less Rands R1 will buy more
dollars
Changes in flexible Exchange rates
Changes in demand or supply in the foreign exchange market
Appreciation of the Rand (Depreciation of the Dollar)
,Caused by an increase in the demand for Rands (increase in supply of dollars) or a decrease
in the supply of Rands (decrease in demand of dollars). Anything that shifts the demand
curve to the right (Increase) or the supply curve to the left (Decrease)
Depreciation of the Rand (Appreciation of the Dollar)
Caused by a decrease in the demand for Rands (decrease in supply for dollars) or an
increase in the supply of Rands (increase in demand for dollars). Anything that shifts the
demand curve to the left or the supply curve to the right.
Factors that shift demand and supply
Import from US
Increase in demand for imported goods from US due to increase in incomes in SA
This causes DD for dollars to shift to the right
The exchange rate to increase
This implies appreciation of dollar and depreciation of the rand
Interest rate in SA
Higher interest rate in SA relative to US
Attract American investors to invest in SA
Increase the supply of dollars
Depreciation of dollar and appreciation of rand
Speculation
If the dollar is expected to decrease
Decrease in demand for dollars
Exchange rate falls
Depreciation of the dollar and appreciation of rand
Inflation
higher inflation in SA
US goods are relatively cheaper so increase in demand for US goods
Increase in demand for dollars
Appreciation of dollar and depreciation of rand
, When SA currency appreciates:
Demand for SA products and demand for SA Rands, Qd decreases
When SA currency appreciates:
Demand for US products Demand for US dollars increases
Example: What happens to the SA goods when the rand appreciates from E0 to E1?
e.g. To buy R100 barrels of SA wine:
E=$/R Cost of Wine (R) Cost of Wine ($)
E0 E= $0.08/R R100 8$
E1 E= $0.10/R R100 10$
SA wine has become relatively more expensive.
Example: What happens to the US goods market when the rand appreciates from E0 to E1?
e.g. To buy $100 pair of Levi Jeans:
E=$/R E=R/$ $ price R Price
E0 E= $0.08/R R12/$ $100 R1200
E1 E=$0.1/R R10/$ $100 R1000
US products have become relatively cheaper. Imports of US goods increase
What drives exchange rate expectations
Exchange rate expectations are driven by expectations about the fundamental
influences on the exchange rate, namely:
– Exports: world demand for SA exports
– Imports: SA demand for imports
– Interest rates: SA interest rate relative to foreign
Expectations about these variables change the exchange rate through their influence on
the expected exchange rate and the effect is instant.
E.g. an expectation that the SA Reserve Bank will increase interest rate in the near future
will lead to an immediate increased demand for rands by traders and speculators – to
capitalise on higher rand price when interest rate is adjusted upwards.
Arbitrage and interest rate parity and purchasing power parity
Interest rate parity: returns on investment are the same across countries, taking e-rates into
account
Scenario 1: interest rate in US is 3% and in SA it is 8% but dollar expected to appreciate
against the rand.
