Chapter 18.2, Problem 1R

To determine

To discuss: About exchange rate, foreign exchange markets, fixed rate of exchange, International Monetary Funds (IMF), devaluation, flexible exchange rate, depreciation and balance of trade.

Explanation of Solution

Exchange rate: Value of currency of country in terms of currency of another country is known as exchange rate. It is useful in international trade. For example, Country A deals in dollars and sold goods to Country B who deals in yen. Now, Country B will evaluate the cost of goods in yen currency and convert it in dollars to pay for the imported goods.

Foreign exchange markets: These are markets that deals in exchange of currency for the companies or firms that deal in import and export of goods. They allow the converting one currency to another country’s currency.

Fixed rate of exchange: This is traditional way of evaluating the value of currency of one country to another. Under this system, the central bank or the government would set a fixed currency’s exchange rate to price of gold or other country’s currency. This used to make the value of currency more or less stable and thus, predictable for the traders.

International Monetary Funds (IMF): The fixed exchange rate system was backed and supported by International Monetary Funds (IMF). It has various governments as its members who were under an obligation to keep their country’s currency exchange rate more or less fixed. Currently, IMF provides funds (loans) and advice in monetary matters to the developing nations.

Devaluation: It means deliberate devaluing currency of one country to other currencies. For example, 10 units of currency of Country A was equal to 1 unit of currency of Country B. After devaluation by the government, 20 units of currency of Country A is equal o 1 unit of currency of Country B. This means the exports will be cheaper while imports will be costlier for Country A.

Flexible exchange rate: Under this system, the exchange of currency is set by the demand and supply of goods that can be purchased by that currency. For example, the demand for currency A is more than its supply. This will lead to an increase in value of currency A.

Depreciation: If the demand and supply leads to the value of currency falls then it is regarded as depreciation. For example, the demand for currency A is less than its supply. This will lead to an depreciation of currency A

Balance of trade: Goods or services that have been purchased from other countries by the home country are referred to as imports. Goods produced in domestic market and sold, or services that have been rendered, by home country to other countries are referred to as exports. The difference of value of a country’s exports and imports is regarded as balance of trade.