exchange - Exchange Rate June 2011 THE EXCHANGE RATE KEY...

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Exchange Rate June 2011 Department of Economic Research 1 T HE E XCHANGE R ATE K EY D EFINITIONS AND C ONCEPTS 1. How is the exchange rate defined? The exchange rate is the price of a unit of foreign currency in terms of the domestic currency. In the Philippines, for instance, the exchange rate is conventionally expressed as the value of one US dollar in peso equivalent. For example, US$1 = P 44.00. In every exchange rate quotation, therefore, there are always two currencies involved. 2. Why is the exchange rate important? The exchange rate is important for several reasons: s It serves as the basic link between the local and the overseas market for various goods, services and financial assets. Using the exchange rate, we are able to compare prices of goods, services, and assets quoted in different currencies. s Exchange rate movements can affect actual inflation as well as expectations about future price movements. Changes in the exchange rate tend to directly affect domestic prices of imported goods and services. A stronger peso lowers the peso prices of imported goods as well as import-intensive services such as transport, thereby lowering the rate of inflation. For instance, an increase in the value of the peso from US$1:P 50 to US$1:P 40 will lower the price of a $1 per liter gasoline from P 50.00 (P 50 X $1) to P 40.00 (P 40X $1). Exchange rate movements can affect the country’s external sector through its impact on foreign trade. An appreciation of the peso, for instance, could lower the price competitiveness of our exports versus the products of those competitor countries whose currencies have not changed in value. The exchange rate affects the cost of servicing (principal and interest payments) on the country’s foreign debt. A peso appreciation reduces the amount of pesos needed to buy foreign exchange to pay interest and maturing obligations. 3. How is the exchange rate determined? Under the system of freely floating exchange rates, the value of the dollar in terms of the peso, like any commodity or service being sold in the market, is determined by the forces of supply and demand. Under a fixed exchange rate system, a par value rate is set between the peso and the dollar by the central bank. The par value may be adjusted from time to time.
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Exchange Rate June 2011 Department of Economic Research 2 4. How does the exchange rate change? Under a floating exchange rate system, if more dollars are demanded than are offered, the price of the dollar in terms of the peso will tend to increase; that is, it will cost more pesos to acquire one dollar. If, on the other hand, more dollars are offered than are demanded, the value of the dollar in terms of the peso will tend to decrease; that is, it will cost less pesos to acquire one dollar. In contrast, under a fixed rate system, a change in the exchange rate is effected through an official announcement by the central bank. 5.
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exchange - Exchange Rate June 2011 THE EXCHANGE RATE KEY...

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