Module 35
have a price. The price is the exchange rate. The exchange rate rises or falls
EXCHANGE RATE AND INTERNATIONAL TRADE
We discussed in the previous module the reasons why international
trade occurs among nations, its economics significance as well the forces that
effect the operation. This module, on the other hand, will try to examine
another important topic: foreign exchange and the exchange rate observed in
the various nations.
In this module, you will:
1. Define foreign exchange
2. Identify the factors that determine the exchange rate; and
3. Discussed how the exchange rate effects international trade.
FOREIGN EXCHANGE
If a country’s foreign trade suffers from an unfavorable balance of
payments, the country is said to have incurred international debt.
International debts are settled through the use of foreign exchange is
the credit instrument used in paying international debts. Persons with debts
to pay abroad have to buy foreign exchange to settle their obligations.
Foreign exchange is in the form of checks or drafts. A draft is a written order
to pay a certain sum of money to somebody at a definite date. These drafts
or bills of exchange are bought and sold in the market called the foreign
exchange rate.
Exchange Rate
Foreign exchange, as we have already observed, is brought or sold in the
foreign exchange market. There is demand for, and supply of, bills of
exchange. Merchandise exports and all the other items of international trade
that’s give rise to receipt from foreigners create the supply of bills of
exchange, while merchandise imports and all the items of international trade
that gives rise to payments to foreigners create the demand for bills of
exchange.
Like any commodity bought and sold in the market, bills of exchange
depending upon the demand for and supply of bills of exchange. If total
payments to foreigners (demand for bills of exchange) exceed the total
receipts from foreigners, (supply of bills of exchange) the exchange rate
rises. On the other hand, if the opposite happens, the exchange rate falls.
When payments to America exceed receipt from America, the supply of
dollar bills exchange in the Philippines is less than the demand for dollars of
exchange. The price of the dollars in the terms of peso goes up; that is to
say, more pesos that are given in dollar. It is said that the dollar is a at
premium and the peso is at a discount. The opposite happens when the price
of the dollar in terms of pesos falls. In this case, the dollar is at a discount
and the peso, at a premium.
A flexible exchange rate system is one where the exchange rate
between the domestic and foreign currencies is determined by the market
demand, for and the supply of, foreign currency. If the demand for the
foreign currency increases, the exchange rate rises. That is, more domestic
currency is required to purchase one unit of the foreign currency (the
domestic currency depreciates).
A fixed change rate is one where a country pegs its currency at a
given exchange rate and stand ready to defend that rate.
From the end of the Second World War until 1971, the world
operated under a fixed exchange rate system, known as the Bretton Woods
System. The establishment of a flexible exchange rate system started in 1973
when, under the Bretton Woods System, America suffered large and chronic
deficits which is what unwilling to correct. However, the system currently in
operation today is not freely flexible or completely floating because national
monetary authorities intervene in foreign exchange markets to prevent erratic
and unwanted fluctuations in exchange rates. This is referred to as “manage”
or “dirty floating.” Today, there is need to make such an arrangement more
formal by devising acceptable rules for intervening in foreign exchange
market.
Figure 35.1 EQUILIBRIUM EXCHANGE RATE 3. Is there a need to “manage” or “float” the exchange rate? Why or
Why not?

 SYNTHESIS
 There are three types of exchange rate
system 1). The flexible exchange rate system;
2). The fixed exchange rate system; and 3).
The managed exchange rate system. The
flexible exchange rate system characterized
by the non-intervention of the government
and its determined by the supply and the
demand for the foreign currency. On the
other hand, the fixed exchange rate system
characterized by the government determining
the rates of currencies as well as making
necessary adjustment to ensure the continuity
of these rates at a given period of time. In
the managed exchange rate system, the
exchange rate is basically determined by the
supply and demand by the foreign currency,
In figure 35.1 D is the Philippines’ demand curved for dollars and S is but the government intervenes to affect the
the Philippines’ supply curve for dollars. D is downward-sloping because at exchanged rate.
lower peso price for dollars, it is cheaper for the Philippines to import from,  The law of supply and demand is observed
invest and extend loans in the United States. S is upward-sloping because at even in the case of foreign exchange rate
higher peso prices for dollars, it is cheaper foe the United States to import determination. If demand for a nation’s
from, invest in and extend loans to the Philippines. D and S intersect in the currency increases (ceteris paribus), that
equilibrium exchange rate of ₱50=US₴1 and the equilibrium quantity of currency appreciates; if the demand declines,
US300dollarmillion. If D shifts up to D, rate of exchange rises to ₱60=US₴1 that currency depreciates. On the other hand,
if the supply of a nation’s currency increases
(ceteris paribus), that the currency
depreciates; if the supply decreases, the
currency appreciates.
Self-check
1. What is exchange rate?
2. What determines the exchange rate?
 MODULE REVIEW
A. Vocabulary. Define the following terms and use each in sentence.
1. Foreign exchange 3. Exchange rate
2. Currency 4. International debt
B. Review Questions. Answer the following questions.
1. Define “exchange rate.” What determines the exchange
rate?
2. What led to the emergence of the managed or dirty floating
exchange rate system?
3. What is the role of the exchange rate in the Philippines’
trade with other countries?
C. Activities.
Prepare an album about the currencies of ten different countries.
Write a brief history of each currency and its current exchange rate
against the peso.
D. Valuing.
If you were the president of the country, would you encourage
Filipino professionals to work abroad in order to earn foreign currency,
even if it will result in, among others, brain drain? Justify your answer.
Answer to Self - check Questions.
1. Foreign exchange refers to the credit instrument used to pay or
settle international debt. Meanwhile, a draft or bill of exchange
is a written order to pay a certain amount of money to a
someone definite date.
2. The foreign exchange market is where the buying and selling of
drafts or bills of exchange takes place.
3. The exchange rate is the rate or price at which one country’s
currency is exchanged for the currency of the other.
4. The exchange rate is determined by either the government or
market forces, or both.
5. Answers may vary, but should all delve on the idea that
monetary authorities intervene in the foreign exchange market
to prevent erratic exchange rate fluctuations.