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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
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Exchange Rate
• Price of one currency in terms of another
• The rate at which one currency can be exchanged for another e.g.
£1 = $2.00£1 = €1.50
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£
£ £
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Nominal exchange rate
• ER of £1 =RM5.80 means need RM5.80 to buy £1
• are quoted in national newspapers• Since one currency is expressed
against another, nominal ERs are bilateral rates.
• €/$• £/$• ¥/$
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• 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
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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
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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
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Sterling exchange rates: 1980–2003Sterling exchange rates: 1980–2003
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Real Effective ER
• Real ER takes price changes into account
• = effective ER X Domestic Price level
Foreign Price level
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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
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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
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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
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• 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
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• 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
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• 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