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.
- Joshua Aizenman and Jaewoo Lee, The Real Exchange Rate, Mercantilism and the Learning by Doing Externality (National Bureau of Economic Research, 2008);
- Gianluca Benigno and Pierpaolo Benigno, “Exchange Rate Determination Under Interest Rate Rules,” Journal of International Money and Finance (v.27/6, October 2008);
- M. Dominguez and L. L. Tesar, “Exchange Rate Exposure,” Journal Of International Economics (v.68/1, 2006);
- 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);
- Jaewoo Lee, Exchange Rate Assessments: CGER Methodologies (International Monetary Fund, 2008);
- Ronald MacDonald, Exchange Rate Economics: Theories and Evidence (Routledge, 2007);
- 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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