Reasons for buying and selling foreign currencies: workers' remittances

International Trade & Globalisation – Foreign‑Exchange Rates (Section 6.3)

Learning Objective

Explain why individuals, businesses and governments buy and sell foreign currencies, describe how exchange rates are determined, and analyse the effect of workers’ remittances on the foreign‑exchange market and the wider economy.

1. Key Definitions

  • Foreign‑exchange rate (FX rate): the price of one currency expressed in terms of another.


    Example: 1 USD = 50 PHP means the Philippine peso (PHP) is the domestic currency and the US dollar (USD) is the foreign currency.

  • Appreciation: a rise in the value of a currency (it buys more foreign currency).

  • Depreciation: a fall in the value of a currency (it buys less foreign currency).

  • Floating exchange rate: the rate is set by market forces of demand and supply.

  • Fixed (or pegged) exchange rate: the rate is set by the government/central bank and is maintained by buying or selling foreign‑exchange reserves.

  • Workers’ remittances: money that migrant workers send back to their families in their home country.

2. Why Do People Buy and Sell Foreign Currencies?

ReasonWho is involved?Purpose
Trade (imports & exports)Importers, exportersImporters need foreign currency to pay for goods; exporters receive foreign currency for sales abroad.
Travel & tourismTourists, travel agenciesExchange home‑currency for the destination’s currency.
InvestmentInvestors, multinational firmsPurchase foreign assets – e.g., foreign‑direct investment (FDI) or portfolio investment in stocks/bonds.
SpeculationCurrency traders, hedge fundsBuy or sell currencies to profit from expected changes in the exchange rate.
Workers’ remittancesMigrant workers, money‑transfer operatorsConvert earnings into the home‑country currency and send the money home.
Government/central‑bank interventionCentral banks, treasury departmentsBuy or sell foreign‑exchange reserves to stabilise the rate or achieve policy goals (e.g., maintain a fixed peg).

3. Determination of the Exchange Rate – Demand & Supply

The foreign‑exchange market for the home‑country currency (e.g., PHP) can be shown with a simple demand‑and‑supply diagram.

  • Axes:

    • Vertical axis (price): exchange rate expressed as home‑currency per unit of foreign currency (PHP per USD).

    • Horizontal axis (quantity): amount of home‑currency supplied or demanded.

  • Demand for home currency: arises when foreigners need the home currency to buy domestic goods, services or assets (exports, tourism, foreign investment).

  • Supply of home currency: comes from domestic residents who need foreign currency to pay for imports, travel abroad, or send remittances.

  • Equilibrium (E₀, Q₀): the point where the demand and supply curves intersect – this is the prevailing exchange rate.

  • Shifts:

    • Right‑ward shift in demand (e.g., a surge in remittances) → higher exchange rate (appreciation of the home currency).

    • Left‑ward shift in supply (e.g., capital outflows) → also leads to appreciation.

    • Right‑ward shift in supply (e.g., increased imports) → lower exchange rate (depreciation).

Diagram placeholder: <figure><img src="fx‑demand‑supply.png" alt="Supply‑and‑demand diagram for home currency"><figcaption>Right‑ward shift in demand (remittances) moves the equilibrium to a higher exchange rate (appreciation).</figcaption></figure>

3.1 Floating vs. Fixed Exchange‑Rate Regimes

FeatureFloating RateFixed (Pegged) Rate
Who sets the rate?Market forces (demand & supply)Government/central bank
How is the rate maintained?Automatic – rates move as market conditions changeCentral bank intervenes by buying foreign currency when the home currency appreciates and selling foreign currency when it depreciates, keeping the rate at the target.
Typical advantagesAbsorbs external shocks; no need for large reserve holdingsProvides certainty for trade and investment
Typical disadvantagesCan be volatile; may affect inflationRequires substantial foreign‑exchange reserves; may become mis‑aligned with fundamentals

4. Workers’ Remittances and the FX Market

  1. A migrant worker in Country A earns income in the host‑country currency (e.g., USD).

  2. To send money home, the worker exchanges USD for the home‑country currency (e.g., PHP) at a bank or money‑transfer service.

  3. The transaction is recorded as a sale of USD and a purchase of PHP in the foreign‑exchange market.

  4. This creates a right‑ward shift in demand for the home currency, tending to appreciate it.

4.1 Example Calculation

Assume the initial rate is 1 USD = 50 PHP. A remittance of USD 10 million is sent to the Philippines.

  • Supply of USD in the market rises by 10 million USD.

  • Demand for PHP rises by the equivalent amount (500 million PHP).

  • If the market adjusts to a new rate of 1 USD = 48 PHP, the percentage change is:

\$\% \Delta E = \frac{48-50}{50}\times100 = -4\%\$

  • The negative sign shows a depreciation of the foreign currency (USD) and, consequently, an appreciation of the PHP.

5. Consequences of Exchange‑Rate Changes

EffectAppreciation of Home CurrencyDepreciation of Home Currency
Import‑price effectImports become cheaper → consumer prices may fall.Imports become more expensive → upward pressure on inflation.
Export‑competitiveness effectExports become more expensive for foreign buyers → export demand may fall.Exports become cheaper for foreign buyers → export demand may rise.
Balance of payments (current account)Potential deterioration if export fall outweighs cheaper imports.Potential improvement as export earnings rise and import spending falls.
Domestic inflationLower import‑price pressure can help contain inflation.Higher import‑price pressure can add to inflation.
Foreign‑exchange reservesCentral bank may need to sell reserves to prevent excessive appreciation.Central bank may need to buy reserves to support the currency.

6. Benefits and Challenges of Remittances for the Receiving Country

  • Benefits

    • Increased household income → higher consumption and poverty reduction.

    • Boost to foreign‑exchange reserves, improving the balance of payments.

    • Funds can be used for education, health, housing and micro‑enterprise development.

    • Potential to stimulate domestic demand and modest economic growth.

  • Challenges

    • Large inflows may cause currency appreciation, reducing export competitiveness (the “Dutch disease” effect).

    • Over‑reliance on remittances makes the economy vulnerable to downturns in host‑country economies.

    • Higher domestic demand can outstrip supply, creating inflationary pressures.

    • Remittance channels may involve high transaction costs or be informal, escaping official statistics.

7. Key Formula

Percentage change in exchange rate

\[

\% \Delta E = \frac{\Delta E}{E_{0}} \times 100

\]

where \(\Delta E = E{\text{new}} - E{0}\) and \(E_{0}\) is the initial exchange rate.

8. Diagrammatic Representation (Suggested Sketches for Exams)

  • Figure 1: Supply‑and‑demand graph for the home‑currency showing a right‑ward shift in demand (remittance inflow) → appreciation.

  • Figure 2: Same graph with a left‑ward shift in supply (central‑bank intervention to prevent appreciation) → depreciation.

  • Figure 3: Fixed‑rate system – horizontal line at the pegged rate with arrows indicating the central bank buying foreign reserves when the currency appreciates and selling reserves when it depreciates.

9. Summary Checklist (Exam‑Ready)

Key PointWhat to Remember
Definition of foreign‑exchange ratePrice of one currency in terms of another (e.g., PHP per USD).
Reasons for buying/selling foreign currencyTrade, travel, investment, speculation, workers’ remittances, government/central‑bank intervention.
How exchange rates are determinedInteraction of demand and supply; floating vs. fixed regimes; central‑bank buying/selling reserves under a peg.
Effect of remittances on the marketIncrease demand for home currency → right‑ward demand shift → possible appreciation.
Consequences of appreciation/depreciationImport‑price, export‑competitiveness, inflation, balance‑of‑payments, reserve‑management effects.
Benefits & challenges of remittancesHigher incomes & reserves vs. risk of appreciation, dependency, inflation.
Key formula for % change in exchange rate\(\displaystyle \% \Delta E = \frac{\Delta E}{E_{0}}\times100\)