Exchange Rates
Exchange Rates
Overview
- An exchange rate refers to the value of one currency in relation to another. It measures how much of one currency can be exchanged for another.
- It’s important in international trade as it impacts the price of a country’s goods and services for those outside its borders, and vice versa.
Types of Exchange Rates
- Fixed Exchange Rates: In this system, the government pegs its currency’s value to another currency or a basket of currencies. Any changes to the exchange rate are made infrequently and only via official announcements.
- Floating Exchange Rates: In this system, the market determines exchange rates depending on supply and demand factors. The value of the currency can frequently fluctuate.
- Managed Float System: This is a mixture of both fixed and floating. The rate is primarily free to float but is occasionally intervened by the Central Bank to prevent extreme fluctuations.
Impact of Exchange Rates
- Exchange rates are positively correlated to the trade balance. If a country’s currency is ‘strong’ (more valued), its exports become more expensive and imports cheaper, causing a trade deficit. Conversely, a ‘weak’ currency (less valued) makes exports cheaper and imports expensive, favouring a surplus.
- Exchange rate fluctuations impact the inflation rate. When the home currency is weak, imported goods cost more, increasing inflationary pressure. On the other hand, a strong home currency makes imports cheaper, which can curb inflation.
- Exchange rate movements affect interest rates and investment. A high exchange rate might deter foreign investment as it raises the cost of entry, while a low exchange rate can encourage foreign investment due to lower setup costs.
Gains and Losses from Exchange Rate Changes
- Those who benefit from a rise in exchange rate are those who import goods or are set to receive income or investment in foreign currencies.
- A drop in exchange rate is beneficial for exporters or those who owe money in foreign currency, as the same amount of foreign money is now worth less in terms of domestic currency.
Exchange Rates and Globalisation
- Globalisation accelerates the movement of goods, services, and capital, enhancing the role and impact of exchange rates.
- Faster and more frequent movements of funds can lead to more volatile exchange rate movements, impacting global trade and investment.
- Multinational corporations have to strategically manage their foreign exchange risks enhanced by globalisation.
Summary of Key Points on Exchange Rates
- The exchange rate is the value of one currency against another, impacting international trade.
- Exchange rates can be classified as Fixed, Floating, and Managed Float.
- Exchange rates have significant economic impacts, including effects on trade balance, inflation, interest rates, and investments.
- Globalisation influences and is influenced by exchange rate volatility, dictating the dynamics of international economics.