The term money refers to the sets of assets which people in addition use to purchase goods and services. Money consists of three functions such as medium, a unit and a store of value. As a medium of exchange, it enables that all article’ are used to complete a transaction. As a unit of account can be defined as a measure which people use to announce costs and register debits, and as a store of
The exchange rate can be defined to the price in one country’s currency expressed to another country’s currency basically is the indicator at which two currencies are traded from one to another. For instance when people in different countries buy from and sell to one another an exchange of these currencies should also take place. Therefore within a certain range of exchange rates, the trade flows in both directions, where each country specializes in manufacturing the goods in which it takes pleasure in a comparative advantage and trade is bilaterally profitable.
The effects on the exchange rates
The actual exchange rate is assessed by the supply and demand of the relevant currencies. For instance when supply in a certain currency it would mean that you will have the demand in another currency. Although the factors which influence the supply and demand of the currencies and also will affect their exchange rates.
There are six different types that affect the exchange rates:
Monetary policy, political situation, balances of payments, interest rates, market judgments and speculations.
Types of the exchange rates
There are two types of exchange rates, normal and real exchange rates. The normal exchange rates are based on currency financed markets which is called as forex markets and are similar to the stock of the exchange markets, while the rates are founded in constant quotation with newspaper updating everyday indication as average or finishing indication in the trade day on a particular market. Furthermore the central bank can also fix the normal exchange rate.
Real exchange rates are normal rate revised somehow by increase injections. For an example if some country has an inflation rate of 30%, while the other country has an inflation of 15% and there is no change in the normal exchange rate take place then the first country will have now a currency which real value is 30% -15=15% larger than was before. The fact is that the greater process means increasing the value of the real exchange rate, other things will stay equal.
Other arrangement of the exchange rate is focused on the numbers of currencies. Bilateral exchange rate obviously links two countries’ currencies. They are often the results of coherence of supply and demand on the financial markets or in banking transitions.
Multilateral exchange rates are calculated in order to estimate basic dynamics of a country’s currency according to the other part of the world. Basket of diversified currencies, selects a more or less consequential set of relative weights, and then computes the effective exchange rate of that country’s currency.
For an example a basket made up of 60% US dollars and 80% German marks a currency that suffered from a value loss of 20% in respect to dollar and 60% to mark will be said having faced an effective loss of 20%x0,8 + 60%x0.6 = 52%.
In some countries enforce the existence of more than one exchange rate, according on the type and the subjects of the transmission. Multiple exchange rates which often exist refer to the commercial or public transmission or consumption and investment imports. This usually requires some degree of capital controls.
Thus in many countries, along the general exchange rate, the black market offers foreign currency to another, generally much higher rates.
Exchange rate systems
Although in a situation when the exchange rate can freely move the certain value that private demand and supply then can together establish freely floating exchange rate and can be the name of currency institutional system. Therefore it’s called flexible exchange rate.
If the central bank timely and significantly goes between on the currency market, a managed floating exchange rate system then can be considered. The central bank intervention may have an explicit target, for instance in term of a band of currency appropriate values.
In freely and managed floating systems, a loss in currency value is called a depreciation on the other hand growth of currency’s international value will be named as appreciation.
But also central banks can announce a fixed exchange rate, offer to supply or buy any quantity of domestic or foreign currencies of that rate.
Within this system a loss of value mostly forced by market or a purposeful policy action, is named as devaluation yet an increase of international value is a revaluation.
The most stabile fixed exchange systems are behind by an international agreement on adequate currency values, usually with a formal obligation of loans across central banks in case of necessity.
A currency crisis is a breakdown of fixed exchange rates with an unfavorable devaluation or even the end of that system in favor of a floating exchange rate. The intention of the public, policymakers and entrepreneur it can dominate. For example if people expecting a crisis can borrow inside the country, convert in a foreign currency, lend that money. But in a crisis times, they sell the bond the convert to the national currency, pay back their loans, and therefore can gain a huge profit.
An extreme national charge to fixed exchange rates is the transformation of the central bank in a currency board with no autonomous influence on monetary stock. The banks will then automatically print or lend money depending on corresponding foreign currency reserves. Therefore, exports imports and capital inflows will comprehensively determine the monetary policy.
Monetary unions phase out the national currencies in favor of one new or the existing one. Some further countries can aim to participate in the union and put in place economic and financial policies to that aim, practically if there are explicit conditions for entering in that monetary area. However, exiting a monetary union can arouse with extensive devaluation of the new national currency. According on trade elasticity’s, on foreign debt of the country, on how the exit is managed and on the overall institutional conditions, this can bring to massive internal poverty or a large export led growth.
Determinants of the nominal exchange
Fixed exchange rates are selected by central banks and they may turn out to be more or less accepted by financial markets.
Differences in floating rates or pressures on fixed rates will derive, as for other financial assets, from three broad categories of determinants:
variables on the real side of the economy;
monetary and financial variables determined in cross-linked markets;
past and expected values of the same financial market with its autonomous dynamics.
1. Exports, imports and their difference influence the demand of currency planned at real transactions. A rising trade surplus will increase the demand for country’s currency by foreigners, so that there should be a pressure for appreciation. A trade deficit should weaken the currency. Were exports and imports are largely established by price competitiveness and were the exchange rate very reacting to trade unbalances, then any deficit would imply depreciation, accompanied by loud exports and falling imports. Thus, the initial deficit would be quickly reversed. Net trade balance would almost always be represented with zero.
2. An even more radical form of real determination of exchange rate is offered by the “one price law”, according to which any good has the same price worldwide, after taken into account nominal exchange rates.
In order to equalize the price of several goods, more than one exchange rate may turn out to be necessary. Although the one price law seems to suffer from too many exceptions to be accepted as the basic definition of exchange rates.
Monetary and financial variables in cross-linked markets
1. Interest rates on Treasury bonds should influence the decision of foreigners to purchase currency in order to buy them. In this case, higher interest rates attract capital from abroad and the currency should appreciate. Decisive would be the difference between domestic and foreign interest rates, thus a reduction in interest rates abroad would have the same effects.
Similarly other fixed-interest financial instruments could be objects of the same dynamics. Accordingly, an increase of domestic interest rates by the central bank is usually considered a way to “defend” the currency.
Nonetheless, it may happen that foreigners rather buy shares instead of Treasury bonds. If this were the strongest component of currency demand, then an increase of interest rate may even provoke the opposite results, since an increase of interest rate quite often depresses the stock market, favoring a tide of share sales by foreigners.
In the same “reversed” direction foreign direct investments would work: a restrictive monetary policy usually depresses the growth perspective of the economy. If FDI are mainly attracted by sales perspectives and they constitute a large component of capital flows, then FDI inflow might stop and the currency weaken.
Needless to say, those conditions are quite restrictive and not so usually met.
A matter of discussion would be whether the relevant interest rate is the nominal or the real one (which, in contrast with the former, keeps into account inflation). Usually foreign investors do not purchase bread, clothes, and the other items included in the bundle used to compute price level and its dynamics: they do not buy anything real in the target economy. So nominal rates are more likely to be taken into account.
As a temporary conclusion, interest rates should have an important impact on exchange rate but one has to be careful to check additional conditions.
2. Inflation rate is often considered as a determinant of the exchange rate as well. A high inflation should be accompanied by depreciation. The more so if other countries enjoy lower inflation rates, since it should be the difference between domestic and foreign inflation rates to determine the direction and the scale of exchange rate movements.
All this would be implied by a weak version of “one price law” stating that price dynamics of a good are the same worldwide, after taking into account nominal exchange rates. Thus, here not absolute level but just the percentage differences in price are requested to be equalized.
If an hamburger costs in Japan 5% more than a year ago, while in USA it costs 8% more, then the dollar should have been depreciated this year by about 8-5=3%.
But in order to equalize the price dynamics of different goods, more than one exchange rate change may turn out to be “necessary”.
In reference to the overall price level of the economy, if exchange rates would move exactly counterbalancing inflation dynamics, then real exchange rates should be constant. On the contrary, this is not true as a strict universal rule.
Still, even if this weak version of the “law” does not always hold, high inflation usually give rise to depreciation, whose exact dimension need not match the inflation itself or its difference with foreign inflation rates.
3. The balance of payments can highlight pressures for devaluation or revaluation, reflected in large and systematic trend of foreign currency reserves at the central bank. In particular, large inflows, due for instance to a rise in the world price of main export items, tend to raise the exchange rate. Conversely, a collapse in the trust of government to manage the economic conditions might provoke a flight of capital, the exhaustion of foreign currency reserves and force devaluation / depreciation.
Autonomous dynamics on the forex market
Activities of forex specialists and investors may turn out to be extremely proper determination of market exchange rate. A sophisticated financial instrument is a feature on exchange rates and may play an important role. Positive feedbacks give rise to bevy behavior and financial fashions.
Fears and affiance in a currency are heterogeneously divided across agents, with a specific events such as unexpected news a realigning them and creating a large movement in the exchange rate.
Impact on other variables
Levels and fluctuations in the exchange rate perform a powerful impact on exports, imports and the trade balance. A high and rising exchange rate tends to depress exports, to boost import and to deteriorate the trade balance, as far as these variables respond to price stimuli. Consumers find foreign goods cheaper so the consumption composition will change. Similarly, firms will reduce their costs by purchasing intermediate goods abroad.
In extreme cases, local firms producing for the domestic market might go bankrupt. If the reason of appreciation was a soaring world price of main exports (e.g. energy carriers, like oil for many oil producing countries), the composition of the industrial texture would be starkly simplified and concentrated to those exports. This is at odds and works in the opposite direction of the diversification of the economy that is often the stated goal of public strategies in countries depending on too few productions (high export concentration).
A devaluation or depreciation should work in the opposite direction, improving the trade balance thanks to soaring exports and falling imports.
If, however, imports have elasticity to price less than 1, their values in local currency will grow instead of falling. Moreover, if the state, the citizens and / or the enterprises have a debt denominated in a foreign currency, their principal and the interests to be paid soar because of the devaluation. They usually squeeze other expenditures and launch a recessionary impulse throughout the economy.
Previous investors in real estate and other assets would be hurt by devaluation, so the perspective of such a dynamics makes investors cautious and might sink FDI.
External debt denominated in foreign currency can, if large enough, provide considerable effects on the positive or negative impact of fluctuation. A devaluation with a large external debt provokes a larger outflows of interest payments (expressed in local currency), possibly squeezing the economy and the public budget, with recessionary effects.
Hosting different industries, regions usually exhibit a differentiated degree of international openness: exchange rate fluctuations will have an uneven impact on them. Similarly, the number of job places and the working conditions may be influenced by the degree of international competition and exchange rates levels.
Exchange rate influences also the external purchasing power of residents abroad, for example in term of purchasing real estate and other assets (e.g. firm equity as a foreign direct investment), so by different channels, also the balance of payments.
Exchange rate devaluation (or depreciation) gives rise to inflationary pressures: imported good become more expensive both to the direct consumer and to domestic producer using them for further processing. In reaction to inflation (actual and feared), the central bank can rise the interest rates, thus sending a recessionary impulse.
Currency crisis have a sweeping impact on income distribution. The few rich able to borrow (because they have collateral and the banks trust them) will get richer and the people purchasing imported goods facing inflation and reduction of real incomes.
Symmetrically, the central bank may use a fixed exchange rate as a nominal anchor for the economy to keep inflation under control, compelling domestic producer to face tougher competition as soon as they decide to increase prices or accept to pay higher wages.
For a small economy, joining a monetary union makes the exchange rate to fluctuate according to fundamentals and market pressures referring to a much larger area, erratically going in directions that are (or are not) coherent with positive macroeconomic developments.
For statistics purposes, international comparisons of current values converted to a common currency are “distorted” by wide exchange rate fluctuations.
In some geographical monetary regions have been enjoyed long periods of stable exchange rate, with moments of consensual realignment after divergence in inflation rates. Many countries try to keep their currency at a fixed level toward the dollar, the Euro or a basket with multiple currencies.
Still the most currencies are progressively devaluate, especially those issued by region countries. The US dollar has extremely wide fluctuations with years of weak and strong dollar.
Business cycle behavior
Too many elements of the exchange rate that will provide a clearly-defined business cycle behavior. To the extent that the exchange rate is issued by the trade balance, the exchange rate is counter-cyclical as the latter. At peaks, the trade deficit would depress the exchange rate, forcing it to depreciate.
If it’s rather the interest rate that turns out to the basic driver of the exchange rate, a capability pro-cyclist of the interest rate would imply a pro-cyclical exchange rate.
The scenario recovery and boom are attended by rising interest rates and exchange rates. At peaks, it can be noticed this is a very strong currency. Together with domestic demand pressures, this would be the source of a high trade deficit.
If autonomous dynamics in the forex market are the major settings of the exchange rate, then intense micro-fluctuations and long term tides will ride the exchange rate, ability with central bank significant interventions.