10. Exchange Rate Policy

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  GN.    AEC,   Gr.11   Economics   Page   1   Unit    2   –   10.   The   Rate   of    Exchange    policy    The   rate   of    exchange   is   the   rate   at   which   one   country’s   currency   is   exchanged   for   another   country’s   currency.   It   is   the   price   of    one   currency   in   terms   of    another.   For   example,   if    the   rate   of    exchange   is   £1   =   $2,   then   the   price   of    a   pound   is   $2   and   the   price   of    a   dollar   is   half    a   pound   or   50   pence.   Countries   may   operate   floating,   fixed   or   managed   exchange   rate   system.   Exchange   rate   systems   1.   Flexible   or     floating   exchange   rate   system   A   floating   exchange   rate   system   is   one   where   the   rates   of    exchange   between   the   domestic   and   foreign   currencies   are   determined   by   the   forces   of    demand   and   supply   without   any   official   (government)   intervention.   It   is   also   known   as   freely   (clean)   floating   or   freely   fluctuating   exchange   rate.   Under   this   exchange   rate   system,   the   rate   at   which   one   currency   exchanges   for   another   depends   on   the   demand   for   and   supply   of    that   currency   in   the   Foreign   Exchange   Market   (FOREX).   Demand     for     pounds   (£)   in   the   FOREX    Pound   is   demanded   by   overseas   residents   (households,   firms   and   governments)   in   the   foreign   exchange   market   when   ã   they   want   to   buy   goods   and   services   from   the   UK,   or   ã   they   wish   to   make   investment   in   Britain   (to   buy   land   and   property   in   the   UK,   buy   shares   in   British   companies,   or   make   loans   to   British   residents,   to   deposit   money   in   UK   banks).   For   these   purposes,   overseas   residents   will   need   pounds,   and   they   will   buy   these   pounds   by   offering   their   own   currencies   in   exchange   for   them.   The   supply    of     pounds   (£)   in   the    foreign   exchange   market    Pound   is   supplied   to   the   foreign   exchange   market   by   British   residents   when   ã   they   wish   to   buy   goods   and   services   from   other   countries,   or   ã   they   wish   to   make   investment   in   other   countries   (buying   land   and   properties   in   other   countries,   buying   shares   in   foreign   companies,   making   loans   to   overseas   residents   and   depositing   money   in   overseas   banks)   For   these   purposes,   UK   residents   will   need   foreign   currencies,   which   they   will   buy   by   offering   pounds   in   exchange   for   them.   The   rate   of    exchange   of    pound   in   the   FOREX   is   determined   where   the   demand   for   pound   is   equal   to   the   supply   of    pound.   The   rate   of    exchange   of    pound   is   expressed   in   terms   foreign   currencies.   This   is   shown   in   figure   1.  
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