Any dramatic changes in the exchange rate of the domestic currency can affect the whole economy. It is because exchange rate stability can very often guarantee the success of international trade in the long-term perspective.
The exchange rate is the price of one currency in terms of another. It measures the value of the domestic currency in terms of foreign currencies. It determines the rate at which one country’s currency can be exchanged for another country’ currency.
Movements in the exchange rate will affect companies. And the impact of price changes of different currencies will depend on whether the business is an importer or an exporter. It is because exchange rates affect the level of exports and imports. Therefore, it will have a significant effect on a business in terms of its sales, costs of production and profits.
The exchange rate is determined by the laws of demand and supply on the foreign exchange market called Forex (FX).
Appreciation and depreciation of a currency
Let’s examine the impact of appreciation and depreciation of the exchange rate on businesses.
1. Appreciation. When demand for a currency exceeds supply, its value will rise which will be reflected in rising price of that currency. This is called an exchange rate appreciation. Now, one unit of the currency will buy more units of other currencies.
An appreciation of the currency will affect the prices paid by importers and exporters. It will benefit importers making imports cheaper. But, it will not benefit exporters making exports more expensive.
2. Depreciation. When supply of a currency exceeds demand, its value will fall which will be reflected in falling price of that currency. This is called an exchange rate depreciation. Now, one unit of the currency will buy less units of other currencies.
A depreciation of the currency will affect the prices paid by importers and exporters. It will benefit exporters making exports cheaper. But, it will not benefit importers making imports more expensive.
What determines exchange rates of currencies?
Any price on a market (in this case the exchange rate) is determined by the forces of supply and demand, market momentum, mood among buyers and sellers, and speculation about the future.
SCENARIO 1: In general, if demand for a currency is high, the exchange rate will rise. If buyers think, or speculate, that demand for a currency will be high in the future, the exchange rate will rise too.
SCENARIO 2: In general, if demand for a currency is low, the exchange rate will fall. If buyers think, or speculate, that demand for a currency will be low in the future, the exchange rate will fall too.
Demand for a currency
There are several factors that determine the demand for and supply of a currency on the foreign exchange market.
Demand for the domestic currency is mainly determined by four factors:
- Foreign buyers of domestic products. If foreign customers from the US want to buy domestic Chinese exports, then the demand for the Chinese RMB will rise.
- Foreign tourists spending money in the country. If foreign tourists from the US travel to China, then the demand for the Chinese RMB will rise.
- Foreign businesses buying raw materials from the country. If foreign companies from the US want to buy raw materials from China, then the demand for the Chinese RMB will rise.
- Foreign investors investing in the country. If investors from the US want to invest in China, then the demand for the Chinese RMB will rise.
Supply of a currency
Supply of the domestic currency is determined by four factors:
- Domestic customers buying products from abroad. If people in China want to buy products from the US, they will have to change the Chinese RMB into the USD$. This will increase the supply of the Chinese RMB in the foreign currency market. This increase in supply may lead to a drop-in value of the Chinese RMB.
- Domestic tourists travelling abroad. If people in China want to travel to the US, they will have to change the Chinese RMB into the USD$. This will increase the supply of the Chinese RMB in the foreign currency market. This increase in supply may lead to a drop-in value of the Chinese RMB.
- Domestic businesses buying foreign imports of raw materials. If domestic businesses in China want to buy raw materials in the US, they will have to change the Chinese RMB into the USD$. This will increase the supply of the Chinese RMB in the foreign currency market. This increase in supply may lead to a drop-in value of the Chinese RMB.
- Domestic investors investing abroad. If Chinese investors want to invest in in the US on NYSE or NASDAQ, they will have to change the Chinese RMB into the USD$. This will increase the supply of the Chinese RMB in the foreign currency market. This increase in supply may lead to a drop-in value of the Chinese RMB
It is worth remembering that the main factors affecting the exchange rate (the price of the currency) are just demand and supply, and future expectations.
