In a floating system, the exchange rate is set by the demand for and supply of the currency.
A floating exchange rate is one set by market forces: the demand for and supply of the currency, without the government fixing it.
Demand for a currency comes from foreigners who want to buy the country's exports, invest in it, or save in its banks. Supply comes from the country's residents selling their currency to buy imports or invest abroad.
The equilibrium exchange rate is where demand for the currency equals supply. Draw it like any demand and supply diagram, with the price of the currency on the vertical axis.
An appreciation is a rise in the value of a currency: it buys more foreign currency. A depreciation is a fall in its value: it buys less.
- Floating exchange rate
- Set by demand for and supply of the currency.
- Appreciation
- Rise in a currency's value.
- Depreciation
- Fall in a currency's value.
Worked example: Reading appreciation and depreciation
Suppose the rate moves from S$1 = US$0.75 to S$1 = US$0.80.
- Each S$ now buys more US dollars.
- So the S$ has appreciated against the US dollar.
- Seen the other way, the US dollar has depreciated against the S$.
- If the rate had moved to S$1 = US$0.70, the S$ would have depreciated.
Watch out for this
The supply of a currency comes from the government printing money.
In the foreign exchange market, the supply of a currency comes from people and firms selling it to buy other currencies, such as importers.
Check your understanding
The rate changes from S$1 = 100 yen to S$1 = 110 yen. What has happened to the S$?
- It has appreciated against the yen.
- It has depreciated against the yen.
- Nothing, because only the yen changed.