Exchange Rate Essay

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An exchange rate is the price of one national currency expressed in terms of another  national currency. Put another  way, the rate of exchange between two currencies, A and B, represents  the amount  of foreign currency  B that  can  be obtained  with  one  unit  of domestic  currency  A (provided  that  such  transactions are permitted).

International trade  necessitates  the  exchange  of currencies  since  producers   will eventually  require payment in terms of their national currency. It is for this  reason  that  American  producers  require  payment  in dollars, Japanese  producers  in yen, British producers  in pounds  sterling, German  producers  in euros, and so on. Exchange rates and exchange rate markets satisfy this need for currencies and are therefore essential elements of the international-payment system that facilitates the trade of goods and services within the global marketplace.

The international economy has experienced a number of different exchange rate regimes that  fall into two broad categories: fixed exchange rates and floating exchange rates. Under a system of fixed exchange rates, the monetary authorities will maintain the value of their currency, in relation to other currencies, at a specific, predetermined rate through the purchase or sale of foreign currency in the foreign exchange market. In contrast,  a floating (or flexible) exchange rate refers to a system where the rate of exchange between two national currencies is determined by supply-and-demand forces in the foreign exchange market. There has been much  debate regarding  the relative merits of these two systems. Since the early 1970s, the major industrialized countries have operated a managed flexible rate system. Through  this system, the monetary authorities  of different countries  do not establish a predetermined rate, but intervene in the foreign exchange  market  in  order  offset major,  potentially destabilizing, exchange rate fluctuations.

Approaches to understanding the movement of flexible exchange rates have tended  to focus on fundamental  variables such as national  price levels and interest  rates. The influence of national  price levels is reflected in the notion  of purchasing  power parity (PPP). This suggests  that  the  rate  of exchange between  two currencies  is equal to the ratio of the prevailing national price levels within these two countries. In other words, exchange rate movements are taken to reflect changes in the rate of inflation in the two countries.  Although  the relative purchasing power of currencies  does serve to explain the trend of exchange rate movements if the inflation differential is large, empirical evidence has demonstrated that it is inadequate  as a general model of exchange rate determination. A number  of factors—such as speculative capital movements—may cause exchange rates to deviate dramatically from their PPP.

Monetary  factors such as capital movements  and interest  rate differentials have also been seen to play important roles in exchange rate determination. Funds will be transferred  from America to Japan, for example, if the rate of interest in Japan is higher than that in America. The influence  of such factors  becomes complicated,  however, since capital movements  also reflect expectations  regarding  future  exchange  rate movements. Currency volatility therefore arises from market participants continuously adjusting their portfolios  in  response  to  evolving short-term  and long-term   expectations   regarding  future  exchange rate movements. It is for this reason that economics still lacks a complete theory of the forces that determine the rate of exchange.

Significant  changes  in  the  rates  of exchange  are defined as either  currency  depreciation  or currency appreciation.  Currency depreciation  refers to a situation where an increased number of units of one nation’s currency are required to purchase one unit of a foreign nation’s currency. For example, an increase in the dollar value of sterling from $1.50 to $2 reflects a depreciation of the dollar. The opposite of currency depreciation  is currency appreciation. In this situation, fewer units of a nation’s currency are required to purchase of unit of a foreign nation’s currency. Thus, a fall in the dollar value of sterling from $2 to $1.50 reflects an appreciation  of the dollar (and, by definition, a depreciation in the sterling value of the dollar).

Within  the foreign exchange market, the value of the currencies may be traded on a “spot” or “forward” basis. The “spot” rate refers to the rate prevailing in the market  at the time the rate is quoted.  The “forward” rate, as the title suggests, refers to the rate at which contracts  are established to buy or sell foreign exchange at some specified future date, i.e., in three months’ or six months’ time. The obvious disadvantage of a freely floating exchange system is that changes in the rate of exchange between currencies can increase the uncertainty of business decisions and significantly alter the profitability of business transactions.  Without the benefits of a fixed exchange rate system, the existence  of forward  exchange  rates  reduces  business uncertainties.  The difference between  the spot rate and the forward rate is determined,  in part, by the  difference between  domestic  and  foreign interest rates, together  with market  expectations  regarding the extent of future appreciation  or depreciation of the currency. This latter point suggests that it not always possible for a business to offset exchange risk through forward exchange transactions. For example, the forward value of a currency will be pushed below its spot value if there is a significant market expectation that its future value will fall.

Bibliography:

  1. Joshua Aizenman and Jaewoo Lee, The Real Exchange Rate, Mercantilism and  the Learning by Doing Externality (National Bureau of Economic Research, 2008);
  2. Gianluca Benigno and Pierpaolo Benigno, “Exchange Rate Determination Under Interest Rate Rules,” Journal of International Money  and  Finance (v.27/6, October  2008);
  3. M. Dominguez and L. L. Tesar, “Exchange Rate Exposure,” Journal Of International Economics (v.68/1, 2006);
  4. Yuko Hashimoto, Random Walk or Run: Market Microstructure Analysis of the Foreign Exchange Rate Movements Based on Conditional Probability (National Bureau of Economic Research, 2008);
  5. Jaewoo Lee, Exchange Rate Assessments: CGER Methodologies (International Monetary Fund, 2008);
  6. Ronald  MacDonald,  Exchange Rate  Economics: Theories and Evidence (Routledge, 2007);
  7. Maurice Obstfeld, Jay C. Shambaugh and  Alan M. Taylor, Financial Stability,  the Trilemma,  and International Reserves (National Bureau of Economic Research, 2008).

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