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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

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

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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

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  1. 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 demandfor a currency • identify items that create a supply for a currency

  2. 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

  3. £ Supose exchange rate is $2.00/ £ £ 10 40,000 $20 $80,000

  4. 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. • €/$ • £/$ • ¥/$

  5. Effective Exchange Rate • 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.

  6. The weights of the currencies of various countriesin the sterling exchange rate index

  7. Trade WeightedIndex (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

  8. Sterling exchange rates: 1980–2003

  9. Real Effective ER • Real ER takes price changes into account • = effective ER X Domestic Price level Foreign Price level

  10. 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

  11. The Flow of Currencies: Whisky sold to Italian hotel Export earnings for UK (Credit on Balance of Payments) € changed to £  dd for £  ss of € Map courtesy of http://www.theodora.com

  12. The Flow of Currencies: Oil from Russia Oil £ 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

  13. 1) Trade in goods n services • 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 __

  14. 2) Investments • 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 __.

  15. 3) Speculation • If expect ER to  , will buy the currency creating __ for the currency • If expect ER to  , will ___ the currency creating __ of the currency

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