Exchange rates

Exchange Rates

Basics of Exchange Rates

  • Exchange rates refer to the value of one currency in terms of another. It allows us to compare the relative value of goods and services across different countries.
  • A country can either have a floating exchange rate, where the value of the currency is determined by market forces of supply and demand, or a fixed exchange rate, where the government or central bank ties the value of the currency to another currency or basket of currencies.

Determinants of Exchange Rates

  • Interest rates: If a country offers high-interest rates, it will attract foreign investors seeking a higher return, thereby increasing the demand for that country’s currency and causing the currency to appreciate.
  • Inflation: If a country has lower inflation compared to others, its purchasing power increases relative to other currencies, thus causing the currency to appreciate.
  • Balance of payments: Higher exports relative to imports will increase the demand for a country’s currency, causing it to appreciate.
  • Economic stability and performance: Foreign investors are attracted to stable economies with strong growth prospects, which can increase the demand for that country’s currency and elevate its value.

Impacts of Exchange Rate Changes

  • Exports and Imports: If a currency appreciates, exports become more expensive and imports cheaper, leading to a worsening trade balance. Conversely, if a currency depreciates, exports become cheaper and imports more expensive, possibly improving the trade balance.
  • Inflation: A depreciation of the currency can cause inflation to increase, as import prices rise, making imported goods and raw materials more expensive.
  • External debt: If a currency depreciates, it becomes more expensive to repay foreign-denominated debt.

Exchange Rate Policy

  • Monetary policy: Central banks can use interest rates to influence exchange rates. Higher rates can increase foreign investment, thereby appreciating the currency.
  • Fiscal policy: Government spending and tax decisions can also affect the exchange rate. A strong economy due to effective fiscal policy can attract foreign investors, leading to currency appreciation.
  • Exchange rate intervention: Central banks might buy or sell their own currency in the foreign exchange market to combat excessive fluctuation of their currency.

Understanding these points about exchange rates will allow you to get a firm handle on how this aspect of the economy interacts with the global economic system.