What is an exchange rate?
If you are travelling to different country, you need to “buy” the local currency
- For example, if the exchange rate from US dollars and the Euro is 1.20, it means €1 would be exchanged for $1.20.
Theoretically, the same product should cost the same amount in different countries when you convert the prices using exchange rates
- For example, if a particular smartphone costs $1000 in the US, it should ideally cost about $833.33 in Europe if the exchange rate is €1 = $1.20
- $1000/€1.20 = €833.33
- However in reality, various factors can cause prices to differ between countries - these will be discussed in depth below
Exchange rates play a crucial role in international trade, affecting the price of imported and exported goods, tourism, and the overall economic relationships between nations.
Exchange rates can either be floating (free) or fixed
A floating exchange rate is a system where the value of a country’s currency is determined by supply and demand in the global foreign exchange market. Unlike fixed exchange rates, floating rates are not controlled by governments or central banks.
Some key points to understand:
- The currency’s value changes freely based on market forces
- It reflects economic conditions of the country relative to others
- Short-term changes can be influenced by various factors like economic news, political events, or market speculation
- Long-term changes often reflect differences in economic strength and interest rates between countries
- While governments don’t directly control the rate, they can influence it through policies or interventions if needed
A fixed exchange rate is a system implemented by a government or central bank that establishes a set value for the country’s currency by linking it to either another nation’s currency or to the price of gold. They are applied to maintain a currency’s value within a narrow range and offer stability for international trade by providing certainty for exporters and importers. This helps governments control inflation, which can lead to lower interest rates and stimulate economic activity.
While fixed rates were once common, most major industrialised nations switched to a floating exchange rate in the early 1970s, however, some developing economics still maintain fixed-rate systems.
To name a few:
- Denmark Krone is pegged to the Euro - 7.47 Krone : 1 Euro
- Hong Kong Dollar is pegged to the US Dollar - 7.83 Dollar : 1 US Dollar
- Nepal Rupee is pegged to the Indian Rupee - 1.61 Rupee : 1 Indian Rupee
- Saudi Arabia Riyal is pegged to the US Dollar - 3.75 Riyal : 1 US Dollar
Exchange rate determination for floating rates
Change in Supply
The exchange rate reaches equilibrium when the demand for a currency equals its supply, here that is an exchange rate of $1 = €1.10. At equilibrium, the value of imports and exports are balanced.
An increase in imports shifts the supply to the right from S$ to S$*. With demand remaining the same, there is a depreciation in the Euro (€) compared to the Dollar ($), down to $1 = €1.05.
Change in Demand
An increase in exports shifts the demand to the right, from D$ to D$*. With supply remaining the same, there is an appreciation of the Euro (€) compared to the Dollar ($), up to $1 = €1.15.
Change in supply and demand
If imports and exports increased at the same level, a new exchange rate equilibrium would be reached and therefore a new trade balance, in which the quantity of dollars would increase to Q2 but the exchange rate would remain the same at $1 = €1.10.
Effective Exchange Rate Index
Think of it like this:
- Normal exchange rate tells you how much of one currency you can get for another, for example, $1 = €0.85
- Effective exchange rate index gives you an overall picture of how a currency is doing against many others
It’s calculated by:
- Looking at exchange rates with several important trading partners
- Giving more importance (weight) to countries that trade more with the country in question
- Combining all these rates into one number
- Comparing this number to a starting point, such as Jan 2005 = 100, which we use in the graph below
- So, the index value for this starting point is set to 100. This doesn’t mean anything by itself - it’s just a convenient number to start with
- All other time periods are expressed in relation to this baseline.
- If the index is > 100, it means the currency has strengthened compared to January 2005 and if it’s < 100, it means the currency has weakened compared to January 2005
It’s a useful measure because countries trade with many other countries, not just one, so the effective exchange rate index gives a better overall picture of a currency’s value in the global market. Let’s have a look at how well the GBP has performed over the last 10 years:
In the learning block Effects of exchange rate changes we look at why it has fluctuated over the years.
Why do exchange rates fluctuate?
These rates are determined in the global foreign exchange (forex) market, where various financial institutions and traders buy and sell currencies continuously
- Operates 24 hours a day
- No central location or single owner
- Exchange rates can fluctuate frequently, sometimes showing small changes and other times experiencing significant shifts
- These fluctuations reflect the constant reassessment of a currency’s value based on current economic conditions and market expectations
What drives exchange rate changes?
- Inflation - Countries with lower inflation rates tend to have stronger currencies because their purchasing power increases relative to other currencies. Conversely, high inflation typically leads to currency depreciation.
- Interest Rate - Higher interest rates usually attract foreign investment, strengthening the currency. Central banks can influence exchange rates by adjusting interest rates, however, the positive effect of high interest rates can be negated if inflation is also high or if there are other significant economic concerns.
- Current Account Balance - A current account deficit means a country is spending more on foreign trade than it’s earning, which can weaken its currency. This occurs because there’s more demand for foreign currencies to pay for imports than there is demand for the domestic currency. Over time this can lead to a depreciation of the exchange rate.
- Public Debt - Large public debts can make a country less attractive to foreign investors. High debt levels can lead to inflation if the government prints money to pay off the debt. Additionally, if investors worry about a country’s ability to pay its debts, they may be less willing to hold that country’s currency or bonds.