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Exchange Rates

Floating Exchange Rate vs. Fixed Exchange Rate

Karim Konsowa

on 2 June 2011

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Transcript of Exchange Rates

Exchange Rates What Are Exchange Rates??? The Exchange Rate is the price of one currency with respect to another. But... WHAT DOES THAT MEAN????? Its basically the price of a currency when you compare it to another currency!! For Example... The exchange rate of 1 Egyptian Pound is 0.16812 when you compare it to the US Dollar The price of 1 US Dollar is 5.91326 when you compare it to the Egyptian pound. SO WHAT?? This means that the price of the Egyptian Pound or EGP is 0.16212 in respect to the US Dollar and the US Dollar is 5.91326 in respect to the EGP But who controls these numbers?? We do!!! BUT HOW???? When we buy foreign goods, our domestic currency is converted into the currency of the good we are buying, so we are selling our domestic currency. So, since there is more supply of our domestic currency on the market, the price of our domestic currency will fall in respect to foreign currencies. The graph shows how when the supply of the EGP increases because more of it is being sold to buy US Dollars, the price of the EGP decreases in terms of the US Dollar There are several factors which control the exchange rate of a currency The Demand of the Currency The demand of the currency is basically, how attractive domestic goods are services are. So, when domestic goods and services become more attractive to consumers, the price of the domestic currency will rise. When domestic goods and services become less attractive to consumers, the price of the domestic currency will fall. BUT WHY DOES THIS HAPPEN??? Because, when domestic goods and services are more attractive to foreign consumers, they will have to sell their currency to buy our domestic currency, which will in turn make the price of our domestic currency increase because the demand for our currency has increased. The Supply of the Currency Domestic Price Level Another way the exchange rate can be affected is through a higher domestic price level. A higher domestic price level, or inflation, makes domestic goods less competitive and reduces their demand. A higher domestic price level results in a depreciation of the domestic currency because domestic goods and services are now less attractive (see demand) From all of this we can extract... THE GOLDEN RULE OF EXCHANGE RATES!!!!! Anything that makes domestic goods more attractive will result in an appreciation of the domestic currency. In contrast, anything that makes domestic goods less attractive will result in a depreciation of the domestic currency. There are two types of Exchange Rates Floating Exchange Rate A Floating Exchange rate is everything you learned in this Prezi. If the currency is controlled by market factors and is not manipulated by the government, the currency is said to have a Floating Exchange Rate. Fixed Exchange Rate Is an exchange rate that is fixed or pegged to another foriegn currency. The way a currency stays fixed or pegged is that the Central Bank has to actively intervene with the currency by buying up the currency if it falls below the pegged value to decrease the suppy of the currency (and increase the demand on the currency), thus making the currency more expensive. Or by selling off foriegn reserves which will make the supply for foreign currencies increase, and thus depreciating the price of foreign currencies, and thus keeping the price of the domestic currency at the pegged value in terms of the foriegn currency. Examples of currencies with a Floating Exchange Rate include (From most to least important):
Egyptian Pound (EGP)
European Union's Euro
Canadian Dollar
Mexican Peso
South Korean Won
Zambian Kwacha
Monopoly's Mr. Monopoly's Dollars
US Dollar Examples of currencies with a Fixed Exchange Rate:
Chinese Renminbi Pros with the Floating Exchange Rate:
The Floating Exchange Rate enables the "Self Equilibrating Mechanism". The theory of the is, when a Balance of Payments Deficit occurs (which is caused by more money from a country being spent in the foreign market than there is being spent on the country's domestic market, then a Balance of Payments Deficit occurs), the currency will depreciate, and since that will mean that goods and services that are being produced domestically are now cheaper and foriegn goods and services are now more expensive, the lower price level will be more attractive to foriegn consumers and therefore there will be more exports and less imports. As the exports increase and imports decrease, the Balance of Payments Deficits will decrease. Cons with Floating Exchange Rate:
The Government has less control how to direct its Economy (to tackle inflation, or to increase Economic Growth)
According to the Video above, the "Self Equilibrating Mechanism" does not always work.
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