Chapter 9

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EXCHANGE RATE(The price of foreign currency against domestic

currency)

Exchange Rate

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= is simply the number of monetary units of one country’s currency to that of one unit of another country’s currency.

= that is the ratio for which one currency to be traded with another.

Types of Foreign Exchange (FOREX) System:

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1. GOLD STANDARD (1920)

2. FLEXIBLE/ FLOATING EXCHANGE RATE SYSTEM (no/less government

intervention).

3. FIXED EXCHANGE RATE SYSTEM (with government intervention)

CHARACTERISTICS of:

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Value of money is equivalent to the gold content.

Its monetary units is in terms of the gold price.

Freedom of selling and buying / exportand import of gold

1. GOLD STANDARD

Exchange rates can fluctuate between gold points (par value)

The rate of exchange: depend on the ratio of gold content

Disadvantages of Gold Standard:

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A cumbersome (rare and difficult) system.are idle resources which are a wastage.Countries did not follow the rules strictly

as their economy gets disrupted.Countries tend to devalue their currencies

in times of deficit BOP.

2. FLEXIBLE / FLOATING EXCHANGE RATE SYSTEM:

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I. Free Floating Exchange Rate System (no government intervention) II. Managed Floating System (1971– 1998) and

from 2005 until now. (less government intervention)

– is when the government does not intervene in the foreign exchange markets, but simply allows the exchange rate to be freely determined by demand and supply in the market.

Determination of Exchange Rate through the market.

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Exchange Rate (RM) SS (price of RM forUS$1) 4.00 2.00 DD0 DD1

Q1 Q0 Quantity of Ringgits

The Exchange Rate is determined by the Market Forces of Demand and Supply of Ringgits.

DEMAND FOR FOREIGN CURRENCY: 

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is a “derived demand” that is related to the debit items in the Balance of Payment account. 

For example, Demand for foreign currency increases when:

  import of goods and services increases. investment in foreign country increases. transfer of payments to residents in

that foreign country increases.

 Factors that may affect the

Demand for Ringgit :

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relative price level of goods – cheaper price will have higher demand on goods larger exports and therefore higher demand for that currency.

high income and wealth. rate of exchange of a currency.high foreign investment – demand for

ringgit rises.expectation of future exchange rate –

speculation purposes.government expenditure overseas.political stability  

SUPPLY OF FOREIGN CURRENCY:

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is derived from the credit items in the Balance of Payment account.

For example: - export of Malaysian goods and

services. - foreign investment in our country. - transfer of payments into our

country.

Ringgit Depreciation

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from the diagram:The ringgit has fallen in value from US$1:

RM4.00 to US$1: RM2.00 – ringgit has depreciated in value,

- after a fall in demand for ringgit (especially

when less goods are exported).

When DD < SS => Exchange Rate will fall (depreciated) and if DD > SS => Exchange Rate will rise (appreciated)BNM will monitor the exchange rate against

currency basket to ensure that the exchange rate remains close to its fair value.

Major foreign exchange rates

(at average buying and selling rates)

4th.Feb. 2005 4th.Sept. 2007

Australia$1 RM2.90 RM2.85

British£1

(sterling pound)

RM7.15 RM7.1

Euro 1 RM4.90 RM4.75

¥ 100 RM3.64 RM3.02

US$1 RM3.80 RM3.51

12(During pegged system) (After pegged system)

Advantages of Flexible Exchange Rate System:

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Exchange rate is determined by FOREX market therefore does not require to keep foreign exchange reserves.

No or less government intervention, therefore less work in monitoring and implementing controls.

Disadvantages of Flexible Exchange Rate System:

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Problems of instability of Exchange Rate – affects to the instability of the

economy. Developing countries will always under

depreciating values. Foreign long-term investment will fall –

instability of FOREX.

3. FIXED EXCHANGE RATE SYSTEM - BRETTON WOOD SYSTEM (1934) (Pegged Exchange Rate System)

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is managed by the national monetary authorities – Bank Negara (meaning that with the intervention of the government.)

The rate of exchange between currencies was pegged within specified narrow limits.

In Malaysia, the Ringgit was pegged to US$1 for RM3.80 from Sept. 2, 1998 and allowed to operate in a managed float on July 21, 2005.

Reason : to reduce the volatility of the RM exchange rate and to promote a stable environment conducive to economic recovery.

Exchange Rate was pegged within narrow limits

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RM

SS

DD

Quantity of Ringgits

Upper limit

Lower limit

3.85

3.80

3.75

To stabilize the FOREX market:

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Government can support the market to stabilize the Exchange Rate from depreciating or appreciating

– to keep the exchange rate stable: through the buying or selling of foreign currency. 

Any excess supply of ringgits need to be bought by the Government using its reserves of foreign currency.

      On the other hand, government needs to sell foreign reserves to support the price of ringgit – under shortages.

 A country may have done DEVALUATION to solve the deficit in the Balance of Payment, that is to devalue her currency and makes her goods becomes cheaper compared to others in terms of domestic currency (ringgit).

Instead, an APPRECIATION (REVALUATION) of ringgit

might solve the Surplus in the BOP.

ADVANTAGES OF FIXED EXCHANGE RATE SYSTEM:

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* No speculative activities – minimum uncertainties. * Low risk in exchange rate fluctuation – not necessary for hedging. * A country is insulated from external financial instability.

DISADVANTAGES OF FIXED EXCHANGE RATE

SYSTEM:

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Central bank need to have sufficient foreign exchange reserves to stabilize the Ringgit.

under Flexible Exchange Rate System, foreign exchange reserves is not necessary.

GOLD DINAR

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to be adopted as a substitute currency for international trade – as it is more stable and less prone to speculative activities.

Being a neutral currency, is also an ideal instrument to facilitate trade among Islamic countries.

Gold Dinar is used to settle:bilateral trade payment - Bilateral Payment Arrangement (BPA)multiple trade payment - Multiple Payment Arrangement

(MPA)  

Transfer of beneficial ownership

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Gold Dinar will not exist in physical transfer but only of beneficial ownership in respective accounts and may be settled in every 3 months or so.

The payment will be assigned a value of gold: For example: 1 gold dinar ≡ 1 ounce of gold The price of 1 ounce of gold = US$290 and US#1 = RM3.80 . Therefore, 1 gold dinar = US$290 = RM (290 X 3.80) = RM1102.

EXCHANGE RATE FROM ISLAMIC PERSPECTIVE (As-Sarf)

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To facilitate international trading Islam permits the trading of different currencies.

To avoid the involvement of riba, transaction must be of the same commodities and was taken place at the spot).

2 types of riba involves here, either riba Al-Fadhlu (because of different commodities traded) or riba An-Nasiah (because of the place of transactions does not take place on the spot). So transactions of money represent commodities being traded at the same time.