Exchange Rates

I. Understanding Exchange Rates

• The exchange rate refers to the price of one currency in terms of another. This greatly impacts international trade.
• Two forms of exchange rates are fixed exchange rates and floating exchange rates. Fixed exchange rates are determined by governments, while floating exchange rates fluctuate based on market demand and supply.
• A strong currency buys more of another currency. Conversely, a weak currency buys less of another currency.
• Appreciation happens when the currency strengthens, while depreciation happens when the currency weakens, in a floating exchange rate system.

II. Factors Influencing Exchange Rates

• Interest rates: Higher interest rates lure foreign investors, hence increasing demand for the home country’s currency and causing it to appreciate.
• Inflation: A country with lower inflation rates will see an appreciation in its currency value.
• Current account balance: A surplus equates to net inflow of foreign currency, which will lead to currency appreciation.
• Political stability and economic performance: Countries with less political risk are more attractive to foreign investors, appreciating the currency.

III. Impact of Exchange Rates on the Economy

• Trade: An appreciation makes imports cheaper and exports more expensive, possibly leading to a current account deficit. Conversely, a depreciation can improve the trade balance.
• Inflation: A depreciation increases import prices, leading to cost-push inflation, while an appreciation may reduce inflation.
• Growth: Depreciation can stimulate economic growth by making exports more competitive. However, an appreciation might slow down the economy.
• FDI (Foreign Direct Investment): Fluctuations in exchange rates can affect FDI. A depreciation could make a nation’s assets seem cheaper, leading to increased foreign investment.

IV. Problems with Fluctuating Exchange Rates

• Uncertainty: Fluctuating exchange rates make future planning challenging, especially for businesses involved in international trade.
• Speculation: Volatile exchange rates may lead to speculative activities which can in turn exacerbate exchange rate volatility.
• Inflation risks: Rapid depreciation may increase inflation pressures, especially for economies heavily reliant on imported goods.

V. Management of Exchange Rates

• Central banks can intervene in the foreign exchange market to stabilise the currency via foreign exchange reserves.
• Monetary policy changes, such as adjustments in interest rates, can also be used to manage exchange rates.
• Countries can also opt for a managed float, which allows the exchange rate to float within a set band or range, or opt for a fixed exchange rate system, though this reduces the ability to respond to external economic shocks.