Understanding Exchange Rates

August 26, 2021
understanding exchange rate

The real exchange rate, which specifies the rate of exchange between local goods and their overseas counterparts, is one of the most important relative prices in an economy. Also as result, changes in the exchange rate have ramifications for the entire economy, which are mostly transmitted through international trade. Because the exchange rates of its two major members, the United States and Japan, have deviated significantly from trends during the last two decades, the consequences of exchange rate changes on the economy are particularly crucial in the International changes. The growth and subsequent collapse of the US dollar in the mid-1980s, as well as the yen’s appreciation after 1993, had a substantial impact on regional trade ties.

It’s important to distinguish between the effects of day-to-day exchange rate volatility and more persistent exchange rate fluctuations when analyzing the relationship between real exchange rates (defined as the relative pricing of goods in various nations) and commerce. The early 1970s saw the breakdown of the Bretton Woods fixed exchange rate regime, which led to the widespread adoption of floating exchange rates. The amount of exchange rate volatility increased dramatically as a result of this transformation, with day-to-day and month-to-month fluctuations becoming much larger.

The influence of both forms of exchange rate behavior on commerce within the International changes is evaluated based on the data. The implications of medium-term changes in the currency rate will be a major focus. The real exchange rate is regularly found to be one of the primary determinants of both exports and imports in empirical trade equations. 

Exchange Rates are influenced by several factors

Inflationary Differentials

A country with a continually lower inflation rate typically sees its currency value rise as its purchasing power grows in relation to other currencies. Japan, Germany, and Switzerland had low inflation in the final part of the twentieth century, but the United States and Canada did not reach low inflation until much later.

Countries with higher inflation generally see their currencies depreciate against their trading partners’ currencies. Higher interest rates are frequently associated with this.

Interest Rate Differentials

Interest rates, inflation, and currency exchange rates are all closely linked. Central banks control both inflation and exchange rates through controlling interest rates, and changing interest rates affects both inflation and currency values. Higher interest rates provide a better return to lenders in a given country when compared to other countries.

As a result, higher interest rates attract foreign capital, driving up the currency rate. However, the impact of increased interest rates is lessened if inflation in the country is substantially higher than in others, or if other factors contribute to the currency’s depreciation. Lower interest rates have the inverse relationship, in other words, lower interest rates tend to lower exchange rates.

Deficits in the Current Account

The current account is a country’s trade balance with its trading partners, reflecting all payments for goods, services, interest, and dividends made between countries. A current account deficit indicates that the country is paying more on trade relations than it is earning, and that it is lending money from other countries to cover the shortfall.

To put it another way, the country requires more foreign currency than it earns through export sales, and it supplies more of its own currency than foreigners demand for its goods. Excess foreign currency demand drives down the country’s exchange rate until local goods and services are affordable to foreigners and foreign assets are too expensive to generate sales for domestic interests.

Debt of the State

To pay for public sector projects and government funding, countries will participate in large-scale deficit financing. While this activity boosts the economy at home, countries with huge public deficits and debts are less appealing to overseas investors. What is the explanation for this? A large debt fosters inflation, and if inflation is high, the loan will be serviced and eventually paid off with less expensive real dollars.

Foreigners may be concerned about a huge debt if they believe the country is at risk of defaulting on its obligations. If the risk of default is high, foreigners will be less eager to invest in assets denominated in that currency. As a result, a country’s debt rating (as established by Moody’s or Standard & Poor’s, for example) is an important factor in determining its exchange rate.

Trade Agreements

The terms of trade is a ratio that compares export prices to import prices and is connected to current accounts and the balance of payments. If the price of a country’s exports rises faster than the price of its imports, the country’s terms of trade have improved. Increased trade terms indicate increased demand for the country’s exports.

This, in turn, leads to more export earnings and, as a result, increased demand for the country’s currency (and a rise in its value). The currency’s value will fall in respect to its trading partners if the price of exports rises at a slower rate than the price of imports.

Strong Economic Results

International companies are compelled to invest in countries that are stable and have great economic performance. A country with such attractive characteristics will attract investment dollars away from countries with more political and economic risk. For example, political unrest can lead to a loss of faith in a currency and a flight of capital to more stable currencies.

Honest Thoughts

The real return of a portfolio is determined by the exchange rate of the currency in which the majority of its investments are held. The buying power of income and capital gains received from any returns is obviously reduced when the exchange rate falls.

Furthermore, other income considerations such as interest rates, inflation, and even capital gains from local assets are influenced by the exchange rate. Even though exchange rates are influenced by a slew of complex factors that baffle even the most seasoned economists, investors should have a basic understanding of how currency values and exchange rates affect the rate of return on their investments.