Exchange Rate Dynamics and how the Master influences it

The Free Market Determination of Exchange Rates

In a floating exchange rate system, the value of one currency relative to another is not fixed by government intervention. Instead, it fluctuates based on the continuous interplay of demand and supply for those currencies in the foreign exchange market.

• Demand for a Currency: Demand for a particular currency arises when individuals, businesses, or governments of other countries need that currency to make payments in that country. This could be for:

  • Imports: To pay for goods and services purchased from that country.

  • Investments: To invest in the financial assets (stocks, bonds) or real estate of that country.

  • Tourism: When people travel to that country and need local currency for their expenses.

  • Speculation: Traders buying a currency expecting its value to rise in the future.

  • Remittances: When individuals working in that country send money back to their home country (this creates a supply of the host country’s currency and demand for their home country’s currency in the host country’s forex market).

  • Impact on Exchange Rate: An increase in the demand for a currency, with the supply remaining constant, will lead to an appreciation of that currency. This means it will become more expensive to buy with other currencies. Conversely, a decrease in demand will lead to depreciation.

• Supply of a Currency: The supply of a particular currency comes from individuals, businesses, or governments of that country who want to make payments in other countries. This could be for:

  • Imports: To pay for goods and services purchased from other countries.

  • Investments Abroad: To invest in the financial assets or real estate of other countries.

  • Tourism Abroad: When people from that country travel to other countries and need foreign currency for their expenses.

  • Speculation: Traders selling a currency expecting its value to fall in the future.

  • Remittances: As mentioned above, remittances sent out create a supply of the home country’s currency and demand for the foreign currency in the home country’s forex market.

  • Impact on Exchange Rate: An increase in the supply of a currency, with the demand remaining constant, will lead to a depreciation of that currency. It will become cheaper to buy with other currencies. Conversely, a decrease in supply will lead to appreciation.

Equilibrium: The exchange rate settles at the point where the demand for a currency equals its supply. Any shifts in the underlying economic factors that influence demand or supply will cause the equilibrium exchange rate to adjust.

Example 1: Captain Creating Demand for Foreign Currency

Let’s say a ship registered in India is sailing in international waters and makes a port call in Singapore. While in Singapore, the Captain needs to:

• Pay for Port Services in Singapore Dollars (SGD): This includes berthing fees, pilotage charges, tugboat services, and other local port dues which are typically denominated in the local currency, SGD. To make these payments, the Captain (acting on behalf of the shipping company) needs to exchange Indian Rupees (INR) for Singapore Dollars (SGD) in the foreign exchange market.

In this scenario, the Captain’s action of needing to convert INR to SGD creates demand for Singapore Dollars (SGD) in the forex market. The shipping company, through its representative (the Captain), is essentially saying, “We have INR and we need SGD to pay for services in Singapore.” This contributes to the overall demand for SGD, potentially causing the INR/SGD exchange rate to move in a way that makes SGD slightly more expensive relative to INR (if all other factors remain constant).

Example 2: Captain Creating Supply of Foreign Currency

Now, let’s consider a ship registered in Singapore that has just completed a voyage and arrives at a port in Howrah, West Bengal, India. During its time at sea and in other ports, the ship accumulated some US Dollars (USD) as payment for freight services rendered (shipping goods for international clients who often pay in a widely accepted currency like USD).

While in Howrah, the Captain needs to:

• Pay for Local Expenses in Indian Rupees (INR): This could include local provisions for the crew, minor repairs at the port, or local transportation costs for the crew. To make these payments, the Captain (again, acting for the shipping company) needs to exchange the US Dollars (USD) the ship has earned into Indian Rupees (INR) in the foreign exchange market.

In this situation, the Captain’s action of needing to convert USD to INR creates a supply of US Dollars (USD) in the forex market (specifically, the market dealing with USD/INR transactions in India). The shipping company, through its representative, is essentially saying, “We have USD and we need to sell it to obtain INR for our local expenses in India.” This contributes to the overall supply of USD relative to INR, potentially causing the USD/INR exchange rate to move in a way that makes USD slightly cheaper relative to INR (if all other factors remain constant).

In both examples, the Captain’s actions, driven by the operational needs of the ship and the shipping company, directly participate in the foreign exchange market, either by demanding a foreign currency to make payments or by supplying a foreign currency to obtain the local currency for expenses. These micro-level transactions, when aggregated across all international trade, finance, and travel activities, determine the overall demand and supply for currencies and thus the freely floating exchange rates.