at the end of the lesson u should be able to: understand

• meaning of exchange rate (ER) • meaning of Nominal ER• meaning and formula of Effective ER• meaning of Trade Weighted ER • calculate Trade Weighted ER • meaning of Real ER• identify items that create a demand for a currency• identify items that create a supply for a currency

Exchange Rate

• Price of one currency in terms of another

• The rate at which one currency can be exchanged for another e.g.

£1 = $2.00£1 = €1.50

£

£ £

Nominal exchange rate

• ER of £1 =RM5.80 means need RM5.80 to buy £1

• are quoted in national newspapers• Since one currency is expressed

against another, nominal ERs are bilateral rates.

• €/$• £/$• ¥/$

• measures the value of a currency against a basket/group of currencies

• multilateral rate • Trade Weighted Exchange Rate is used• in index form • the weight accorded to each currency

depends on the proportion of trade done with the country.

• the larger the size of the trade, the larger the weightage.

Effective Exchange Rate

The weights of the currencies of various countries

in the sterling exchange rate index

The weights of the currencies of various countries

in the sterling exchange rate index

Trade Weighted Index (TWI)

• UK’s trade with US – 70% trade with France – 30%

• If £ 10% against USD

• £ 20% against €

• % = (-10% x 0.7) + (-20% x 0.3)

= - 7% - 6%

= - 13%

TWI = 100 - 13 = 87

Sterling exchange rates: 1980–2003Sterling exchange rates: 1980–2003

Real Effective ER

• Real ER takes price changes into account

• = effective ER X Domestic Price level

Foreign Price level

DD & SS of Currencies

• Exchange rates are determined by the demand for and the supply of currencies on the foreign exchange market (forex)

• The demand and supply of currencies is in turn determined by:– International Trade in G & S– Investments – Speculation

The Flow of Currencies:

Whisky sold to Italian hotel

€ changed to £ dd for £ ss of €

Export earnings for UK(Credit on Balance of Payments)

Map courtesy of http://www.theodora.com

The Flow of Currencies:

Oil

Oil from Russia

£ changed into Roubles

dd for roubles ss of £ Export earnings for Russia

Import expenditure for the UK(Debit on balance of payments)

Map courtesy of http://www.theodora.com

• X creates __ for the currency & M creates __ of the currency.

• e.g. DD by Italians for British’s whisky creates a ___ for £ and a ___ of €

• DD by Britons for Russian oil creates a ___ for roubles and a __ of __

1) Trade in goods n services

• Inward investment to an economy creates a ___ for its currency.

• Outward investment from an economy creates a ___ of its currency.

• British Telecom investing in M'sia creates a

dd for __ and a ss of __ • YTL Malaysia investing in UK create a dd for

__ and a ss of __.

2) Investments

• If expect ER to , will buy the currency creating __ for the currency

• If expect ER to , will ___ the currency creating __ of the currency

3) Speculation