Definitions of floating exchange rate, appreciation and depreciation

International Trade and Globalisation – Foreign Exchange Rates

Learning Objectives

• Define a floating exchange rate.
• Explain what is meant by appreciation and depreciation of a currency.
• Identify the main reasons why households, firms and governments buy or sell foreign currencies.
• Describe the key determinants that cause a floating exchange rate to move.
• Analyse the likely consequences of a change in the exchange rate for the domestic economy.

Key Definitions

Floating Exchange Rate

Definition: A floating exchange rate is the price of one currency expressed in terms of another currency that is determined by market forces of supply and demand, without direct government or central‑bank control.

Appreciation

An appreciation occurs when the value of a currency rises relative to another currency. In a floating system this happens when demand for the domestic currency exceeds its supply, pushing the exchange rate in the direction of a stronger domestic currency.

Example: If the rate moves from £1 = $1.20 to £1 = $1.30, the pound has appreciated because each pound now buys more US dollars.

Depreciation

A depreciation is the opposite of appreciation: the domestic currency falls in value relative to another currency because its supply exceeds demand.

Example: If the rate moves from £1 = $1.20 to £1 = $1.10, the pound has depreciated because each pound now buys fewer US dollars.

Why Do Economic Agents Buy or Sell Foreign Currencies?

• International trade – a UK firm buying euros to pay a German supplier (creates demand for euros).
• Investment abroad – a UK investor purchasing US stocks, requiring dollars (creates demand for dollars).
• Speculation – traders buying a currency they expect to rise in value (creates speculative demand).
• Government/central‑bank intervention – e.g., the Bank of England sells pounds to curb an unwanted appreciation (adds supply of pounds and reduces pressure on the exchange rate).
• Remittances – migrant workers sending money home, converting foreign earnings into the domestic currency (creates supply of foreign currency).
• Profit‑repayment – multinational companies converting foreign‑currency profits back into the home currency (creates supply of foreign currency).

Determinants of Exchange‑Rate Movements (Floating System)

Demand‑side drivers (shifts in demand for the domestic currency)

• Export demand – higher foreign demand for domestic goods raises demand for the domestic currency.
• Foreign‑direct investment (FDI) inflows – overseas investors need the domestic currency to set up operations.
• Speculative expectations of appreciation – investors buy the currency in anticipation of a rise.
• Interest‑rate differentials – higher domestic interest rates make domestic assets more attractive, increasing demand for the currency.

Supply‑side drivers (shifts in supply of the domestic currency)

• Import demand – more imports mean domestic buyers need foreign currency, increasing the supply of the domestic currency.
• Capital outflows – domestic investors moving money abroad increase the supply of the domestic currency.
• Speculative expectations of depreciation – investors sell the currency to avoid losses, adding to supply.
• Central‑bank intervention – selling foreign reserves for the domestic currency adds to supply of the foreign currency (and reduces supply of the domestic currency).

Other influences

• Relative price‑level changes (inflation differentials).
• Political stability and overall economic performance.
• Terms‑of‑trade shocks (e.g., a sudden rise in oil prices for an oil‑importing country).

Comparison of Floating and Fixed (Pegged) Exchange Rates

Consequences of Exchange‑Rate Changes

• Trade balance – depreciation makes exports cheaper and imports more expensive, tending to improve the trade balance; appreciation has the opposite effect.
• Import and export prices – a stronger currency lowers the domestic price of imported goods (reducing inflationary pressure) but raises the price of exported goods abroad.
• Inflation – depreciation can import inflation by raising the cost of imported inputs; appreciation can help contain inflation.
• Investment flows – higher interest rates that attract foreign capital can cause appreciation; capital flight can trigger depreciation.
• Tourism – a weaker domestic currency makes the country cheaper for foreign tourists (boosting receipts) and makes outbound travel more expensive for residents.
• External‑debt servicing – depreciation raises the domestic‑currency cost of repaying foreign‑currency debt.

Illustrative Diagram

Key Points to Remember

1. In a floating system the exchange rate is set by market forces, not by the government.
2. Appreciation = domestic currency becomes stronger; depreciation = domestic currency becomes weaker.
3. Buying and selling of foreign currency is driven by trade, investment, speculation, remittances, profit‑repayment and government actions, each linked to a demand‑ or supply‑side driver.
4. Factors that shift demand or supply in the foreign‑exchange market include export/import volumes, interest‑rate differentials, expectations, and central‑bank interventions.
5. Changes in the exchange rate affect import/export prices, the trade balance, inflation, tourism, external‑debt costs and overall economic growth.

Sample Examination Question

Explain how a depreciation of the domestic currency can affect the country's trade balance. Use appropriate economic terminology and give at least two specific effects.