International Trade and Globalisation – Foreign Exchange Rates
Cambridge IGCSE Economics (0455)
Topic: International Trade and Globalisation – Foreign Exchange Rates
Objective
Explain the reasons why individuals, firms and governments buy and sell foreign currencies, with particular focus on investment in capital goods between countries.
Key Concepts
Foreign currency – the money of another country, e.g., US dollars (USD), euros (EUR), Japanese yen (JPY).
Foreign exchange market – the global market where currencies are bought and sold.
Exchange rate – the price of one currency expressed in terms of another.
Capital goods – durable goods used to produce other goods and services, such as machinery, equipment and factories.
Why Do Economic Agents Buy Foreign Currency?
Importing capital goods – A firm in Country A needs to purchase machinery from Country B. To pay the supplier, the firm must obtain Country B’s currency.
Foreign direct investment (FDI) – When a company sets up a subsidiary or acquires assets abroad, it must convert its home currency into the host‑country currency.
Portfolio investment – Investors buy foreign bonds or equities, requiring conversion into the foreign currency.
Speculative motives – Traders buy a currency expecting its value to rise, allowing a profit on later sale.
Travel and tourism – Individuals need foreign currency to pay for overseas holidays, though this is less relevant to capital‑goods investment.
Why Do Economic Agents Sell Foreign Currency?
Export earnings – A firm that sells capital goods abroad receives foreign currency, which it must convert back into its home currency to pay domestic costs.
Repatriation of profits – Multinational enterprises bring home profits earned in foreign currency.
Debt repayment – If a firm borrowed in a foreign currency, it must sell foreign currency to meet the repayment obligation.
Currency speculation – Selling a currency expected to depreciate can avoid losses.
Link Between Capital‑Goods Trade and Foreign‑Exchange Transactions
When a country imports capital goods, the transaction creates a demand for the exporter’s currency. Conversely, when a country exports capital goods, it creates a supply of its own currency. The net effect on the exchange rate depends on the balance of these flows.
Transaction Type
Currency Flow
Effect on Home Currency
Import of capital goods
Home currency → foreign currency
Depreciates (higher demand for foreign currency)
Export of capital goods
Foreign currency → home currency
Appreciates (higher supply of foreign currency)
Foreign‑direct investment (inward)
Foreign currency → home currency
Appreciates
Foreign‑direct investment (outward)
Home currency → foreign currency
Depreciates
Exchange‑Rate Determination (Simplified)
In a floating exchange‑rate system, the rate adjusts to equate the quantity of currency demanded with the quantity supplied.
\$\$
E = \frac{D}{S}
\$\$
where \$E\$ is the exchange rate (units of home currency per unit of foreign currency), \$D\$ is the total demand for the foreign currency, and \$S\$ is the total supply of the foreign currency.
Illustrative Example
Suppose a UK car manufacturer wants to buy \$10\$ million USD worth of robotic arms from Japan. The current GBP/USD rate is \$0.80\$ (£ per \$1\$ USD). The cost in pounds is:
\$\$
\text{Cost in GBP} = 10{,}000{,}000 \times 0.80 = £8{,}000{,}000.
\$\$
If the demand for USD rises because many firms are importing similar equipment, the GBP/USD rate might fall to \$0.75\$. The same \$10\$ million USD would then cost £7.5 million, reducing the UK firm’s expenditure.
Implications for Policy Makers
High demand for foreign currency to finance capital‑goods imports can put downward pressure on the home currency, potentially raising the cost of all imports.
Governments may intervene (e.g., foreign‑exchange reserves, monetary policy) to stabilise the currency and protect domestic investment.
Encouraging inward FDI can increase the supply of foreign currency, supporting currency appreciation.
Suggested diagram: Supply‑and‑demand graph for a foreign currency showing how an increase in demand (e.g., due to capital‑goods imports) shifts the demand curve leftward, leading to depreciation of the home currency.
Summary Checklist
Identify the main reasons for buying foreign currency in the context of capital‑goods investment.
Identify the main reasons for selling foreign currency in the same context.
Explain how these transactions affect the supply and demand for currencies and thus the exchange rate.
Use the simple exchange‑rate formula \$E = D/S\$ to describe the relationship.
Consider the policy responses that a government might adopt.
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 UK factory. Show how this transaction affects the GBP/JPY exchange rate.
Discuss two ways in which a government can mitigate the adverse effects of a depreciating currency caused by high demand for foreign capital goods.