Answer to Question #162970 in Macroeconomics for ATEEB AHMED

Question

The foreign exchange rate is the price of one currency in terms of another currency. With the help of an example graphically determine the foreign exchange rate also discuss the appreciation and depreciation of a currency in terms of another currency.

Answer 1

Suppose Kenya and Uganda are trading partners. Kenya's currency is in the Kenyan shilling (ksh

)and Ugandan currency is in Ugandan shilling(Ugsh). We can represent the market for the Kenyan shilling in the foreign exchange market, as shown below:

For example In order for Uganda to import more goods from Kenya, it will need more Kenyan shillings to buy Kenyan goods. Therefore, the demand for the Kenyan shilling will increase. As a result of an increase in the demand for the Kenyan shilling, the exchange rate will increase (in other words, it will take more Ugandan shilling to buy each Kenyan shilling).

Currency depreciation is a fall in the value of a currency in terms of its exchange rate versus other currencies. A currency depreciates when you need less of another currency to buy a single unit of another currency. Currency depreciation can occur due to factors such as economic fundamentals, interest rate differentials, political instability, or risk aversion among investors.

Currency appreciation is an increase in the value of one currency in relation to another currency. A currency appreciates when you need more of another currency to buy a single unit of another currency. Currencies appreciate against each other for a variety of reasons, including government policy, interest rates, trade balances, and business cycles.