> FOREIGN EXCHANGE RATE

BY SITI ROHANA, NURUL NAZIRA DAN RIDATUL AFIDA 

FOREIGN EXCHANGE RATE

Foreign exchange rate is the price per unit of foreign currency are presented in local currency in terms of foreign currency. While the foreign exchange market refers to the interaction between demand and supply for converting from one currency to another currency. The exchange rate has two systems which are flexible exchange rate system and the system of fixed exchange rates. The flexible exchange rate system is foreign exchange rate determined by the interaction of demand and supply of foreign currency in the market. While the fixed exchange rate system is the foreign exchange rate set by the government with the aim of improving the balance of payments and economic development.

FLEXIBLE EXCHANGE RATE SYSTEM

The exchange rate of foreign currency in the flexible exchange rate system is determined by the interaction between demand and supply of foreign currency in the market.

The figure above shows the exchange rate between the Malaysian ringgit to the US dollar. The equilibrium is achieved at point E when the US Dollar demand curve (DD) supply curve intersects the US Dollar (SS) at the exchange rate of US $ 1.00 = RM3.60.

Assuming the exchange rate increased to US $ 1.00 = RM3.80. This means the Malaysian Ringgit depreciated. This results in significant excess supply of US dollars in the market Q2Q1. Surplus of US dollar led exchange rate resulted decrease until it reaches equilibrium again at point E when DD = SS on the exchange rate US $ 1.00 = RM3.60.

Assuming the exchange rate down to US $ 1.00 = RM3.40. This means Ringgit Malaysia experienced a rise in value. This resulted in a surplus demand of US Dollars Q2Q1 in the market. The shortage for US Dollars led exchange rate to increase until it reaches equilibrium again at point E when DD = SS on the exchange rate US $ 1.00 = RM3.60.

ADVANTAGES OF FLEXIBLE EXCHANGE RATE SYSTEM

1. Shock Absorber

A fluctuating exchange rate system protects the domestic economy from the shocks produced by the disturbances generated in other countries. Thus, it acts as a shock absorber and saves the internal economy from the disturbing effects from abroad.

2. Independent Monetary Policy

Under flexible exchange rate system, a country is free to adopt an independent policy to conduct properly the domestic economic affairs. The monetary policy of a country is not limited or affected by the economic conditions of other countries

DISADVANTAGES OF FLEXIBLE EXCHANGE RATE SYSTEM

1. Unstable conditions

Flexible exchange rates create conditions of instability and uncertainty which, in turn, tend to reduce the volume of international trade and foreign investment. Long-term foreign investments arc greatly reduced because of higher risks involved.

2. Inflationary Effect

Flexible exchange rate system involves greater possibility of inflationary effect of exchange depreciation on domestic price level of a country. Inflationary rise in prices leads to further depreciation of the external value of the currency.

FIXED EXCHANGE RATE SYSTEM

Fixed exchange rate is the exchange rate set by the government. Aiming to improve the balance of payments and economic development. Government can set the foreign exchange rate is higher or lower than that set by the market mechanism in the foreign exchange market.

GRAPH A    

                                                              

        

GRAPH A

Point E is the equilibrium foreign exchange rates. When the government fixed the exchange rate of USD1 = RM4.00. Then there is the excess supply of US dollars Q1Q2. For defending the exchange rate set by the government, the government should buy the excess supply. If not market mechanisms will force a higher exchange rate was down to the exchange rate market. If not, market mechanisms will force that higher exchange rate go down to the exchange rate market.

GRAPH B

GRAPH B

Point E is the equilibrium of foreign exchange rates. When the government fixed the exchange rate of USD1 = RM3.80. Then there is excess demand for US dollars by Q1Q2. In order to maintain the exchange rate set by the government, then the government must have reserves of US dollars. If no market mechanisms will force a higher exchange rate was up to the exchange rate market.

ADVANTAGES OF FIXED EXCHANGE RATE SYSTEM

1. Avoid Currency Fluctuations

If the value of currencies fluctuate significantly this can cause problems for firms engaged in trade. For example, if a firm relied on imported raw materials devaluation would increase the costs of imports and would reduce profitability.

2. Keep inflation Low

Governments who allow their exchange rate to devalue may cause inflationary pressures to occur. This is because AD increases, import prices increase and firms have less incentive to cut costs.

DISADVANTAGES OF FIXED EXCHANGE RATE SYSTEM

1. Conflict with other objectives

To maintain a fixed level of the exchange rate may conflict with other macroeconomic objectives. If a currency is falling below its band the government will have to intervene. It can do this by buying sterling but this is only a short term measure. The most effective way to increase the value of a currency is to raise interest rates. This will increase hot money flows and also reduce inflationary pressures. However higher interest rates will cause lower AD and economic growth, if the economy is growing slowly this may cause a recession and rising unemployment.

2. Less Flexibility

It is difficult to respond to temporary shocks. For example an oil importer may face a balance of payments deficit if oil price increases, but in a fixed exchange rate there is little chance to devalue.