Cambridge IGCSE Economics (0455)
Topic: International Trade and Globalisation – Foreign Exchange
Objective
Explain why individuals, firms and governments buy and sell foreign currencies – with particular reference to the purchase and sale of capital goods between countries – and describe how these transactions affect exchange‑rate movements.
1. Key Definitions
- Foreign currency – the legal tender of another country (e.g., US $ dollar, euro €).
- Foreign‑exchange market (Forex) – the global over‑the‑counter market where currencies are bought and sold.
- Exchange rate – the price of one currency expressed in terms of another (e.g., £0.80 per $1). It tells us how much of the home currency is needed to obtain one unit of the foreign currency.
- Capital goods – durable items used to produce other goods and services, such as machinery, equipment, factories and technology.
2. Exchange‑Rate Regimes (Syllabus 6.3.3)
- Floating (flexible) rate – the exchange rate is determined by market forces of supply and demand. It moves up or down as the quantity of foreign currency demanded or supplied changes.
- Fixed (pegged) rate – the government or central bank sets a target rate and maintains it by intervening in the Forex market. Intervention usually involves buying or selling foreign reserves so that the market price does not move away from the official parity.
3. Why Agents Buy Foreign Currency
Agents need foreign currency when a transaction is priced in that currency.
- Firms
- Importing capital goods (machinery, equipment, technology) – payment is made in the exporter’s currency.
- Outward foreign‑direct investment (FDI) – setting up a subsidiary, acquiring assets or land overseas.
- Portfolio investment – buying foreign bonds, shares or other securities.
- Servicing foreign‑currency debt – interest and principal repayments.
- Speculative motive – buying a currency in anticipation that its value will rise.
- Individuals
- Travel and tourism – cash or card payments abroad.
- Remittances – workers sending part of their earnings home in the home currency (requires conversion of foreign earnings into the home currency).
- Governments
- Building foreign‑exchange reserves – buying foreign currency to increase reserves.
- Intervention to prevent excessive appreciation – buying foreign currency to support the home currency.
- Disbursing aid, paying for overseas procurement or servicing external debt.
4. Why Agents Sell Foreign Currency
- Firms
- Export earnings – converting foreign currency received from selling goods (including capital goods) into the home currency to meet domestic costs.
- Repatriation of profits – bringing home earnings of overseas subsidiaries.
- Debt repayment – converting foreign currency to meet obligations denominated in the home currency.
- Speculative motive – selling a currency expected to fall in value.
- Individuals
- Receiving remittances – converting foreign currency sent from abroad into the home currency.
- Returning from a holiday – exchanging any remaining foreign cash back into the home currency.
- Governments
- Reserve management – selling foreign reserves to support the home currency (especially under a fixed regime).
- Intervention to curb depreciation – selling foreign currency to reduce excess demand for it.
5. Capital‑Goods Trade and Foreign‑Exchange Flows
| Transaction | Direction of Currency Flow | Typical Effect on Home Currency |
|---|
| Import of capital goods | Home currency → foreign currency | Depreciation (higher demand for foreign currency) |
| Export of capital goods | Foreign currency → home currency | Appreciation (higher supply of foreign currency) |
| Outward FDI (investment abroad) | Home currency → foreign currency | Depreciation |
| Inward FDI (foreign investment at home) | Foreign currency → home currency | Appreciation |
6. Determinants of Demand and Supply for Foreign Currency
| Factor (Demand‑side) | Effect on Demand for Foreign Currency |
|---|
| Imports of capital goods (and other imports) | ↑ – more home currency is exchanged for foreign currency. |
| Outward FDI | ↑ – funds are sent abroad. |
| Portfolio investment abroad | ↑ – purchase of foreign assets. |
| Higher foreign interest rates (relative to home) | ↑ – investors seek the higher‑yielding foreign currency. |
| Higher foreign inflation (relative to home) | ↓ – foreign goods become relatively more expensive, reducing demand for that currency. |
| Speculative expectations of future depreciation of the home currency | ↑ – agents buy foreign currency now to avoid a loss. |
| Factor (Supply‑side) | Effect on Supply of Foreign Currency |
|---|
| Exports of capital goods (and other exports) | ↑ – foreign earnings are converted into home currency. |
| Inward FDI | ↑ – foreign investors bring foreign currency into the home country. |
| Portfolio investment in home assets | ↑ – foreign investors buy domestic securities, supplying foreign currency. |
| Higher home interest rates (relative to foreign) | ↑ – attracts foreign capital, increasing supply of foreign currency. |
| Higher home inflation (relative to foreign) | ↑ – domestic goods become less competitive, reducing export earnings; however, the home currency may be sold to purchase cheaper foreign goods, increasing supply of foreign currency. |
| Speculative expectations of future appreciation of the home currency | ↑ – agents sell foreign currency now, expecting to buy it back cheaper later. |
7. Diagrammatic Model (Supply‑and‑Demand)
- Vertical axis: Exchange rate (home‑currency per unit of foreign currency).
- Horizontal axis: Quantity of foreign currency.
- In a floating system the equilibrium exchange rate is where the quantity of foreign currency demanded (D) equals the quantity supplied (S).
- When the UK imports a large amount of capital goods, the demand curve for US \$ shifts rightward. The new equilibrium is at a higher exchange rate (e.g., £0.80 → £0.85 per \$1), meaning the pound depreciates.
- Conversely, a surge in inward FDI shifts the supply curve of foreign currency rightward, lowering the exchange rate (e.g., £0.80 → £0.75 per $1) and causing the pound to appreciate**.
8. Illustrative Numerical Example
Suppose a UK car manufacturer wishes to purchase robotic arms worth US \$10 million from Japan. The current GBP/USD rate is £0.80 per \$1.
Cost in pounds:
\[
\text{Cost (£)} = 10{,}000{,}000 \times 0.80 = £8{,}000{,}000.
\]
If many UK firms also import similar equipment, demand for US \$ rises, shifting the demand curve rightward. The GBP/USD rate might move to £0.85 per \$1 (the pound has depreciated). The same US $10 million now costs:
\[
\text{Cost (£)} = 10{,}000{,}000 \times 0.85 = £8{,}500{,}000.
\]
Thus, a depreciation of the home currency raises the pound‑denominated cost of the imported capital goods.
9. Policy Tools to Counter Unwanted Exchange‑Rate Movements (linked to capital‑goods trade)
- Foreign‑exchange intervention – the central bank sells foreign reserves and buys the home currency to support its value (commonly used under a fixed or managed‑float regime).
- Monetary‑policy adjustment – raising interest rates makes domestic assets more attractive, increasing demand for the home currency and offsetting depreciation caused by high import demand.
- Fiscal incentives for inward FDI – tax breaks or subsidies encourage foreign firms to invest domestically, increasing the supply of foreign currency.
- Exchange‑rate controls or a managed float – imposing limits on the amount of foreign currency that can be bought/sold or smoothing daily fluctuations to reduce volatility for capital‑goods importers.
10. Summary Checklist
- Define foreign exchange, foreign‑exchange market and exchange rate (price of one currency in terms of another).
- Distinguish between floating and fixed exchange‑rate regimes and explain how a fixed rate is maintained.
- List the main reasons firms, individuals and governments buy foreign currency (imports of capital goods, outward FDI, portfolio investment, debt repayment, speculation, reserve accumulation, government intervention).
- List the main reasons they sell foreign currency (export earnings, repatriated profits, inward FDI, debt repayment, reserve management, speculation).
- Explain how each transaction creates a demand or supply of foreign currency and the resulting effect on the exchange rate (appreciation vs. depreciation).
- Identify all determinants of demand and supply (trade flows, FDI, portfolio investment, interest‑rate differentials, relative inflation, expectations, speculative motives).
- Use the supply‑and‑demand diagram correctly: vertical axis = home‑currency per foreign unit; right‑ward shift of demand = depreciation; right‑ward shift of supply = appreciation.
- Recall two policy tools a government can use to mitigate adverse exchange‑rate movements caused by capital‑goods trade, and state which regime each tool is most compatible with.
11. Practice Questions
- Explain why a rise in imports of capital goods from the United States would cause the British pound to depreciate against the US dollar.
- A Japanese firm invests £5 million in a new UK factory. Show how this transaction affects the GBP/JPY exchange rate and indicate whether the pound is likely to appreciate or depreciate.
- Discuss two ways in which a government can mitigate the adverse effects of a depreciating currency that results from high demand for foreign capital goods.
- Differentiate between a speculative motive for buying foreign currency and a government’s motive for buying foreign currency to build reserves.
- Using the supply‑and‑demand framework, illustrate the impact on the exchange rate of a sudden increase in inward foreign‑direct investment.