Assignment Help With Exchange Rate Determination

What do you mean by an exchange rate?

Exchange rate is basically the rate at which the price of one currency is proportional in terms of another. In simpler words, the exchange rate is the main purchasing power of one particular currency in respect to the other currency. This currency which is being compared in the exchange rate is traded in the exclusive foreign exchange markets and stock exchanges. The total volume or amount of money which is being transferred or bought and sold is very high in this type of exchange. An estimate daily foreign exchange market’s usual turnover is over $3 trillion, which makes it one of the most professionalized fields of work. Exchange rates are o ever important tool or instrument for the betterment of the policies which concerns the monetary growth. This implies that the total number of growing countries are continuously intervening in between the currency market places as a whole part of the concerned economic strategies.

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What is the significance of the exchange rate?

The national currency’s exclusive quotation is expressed by the exchange rate with the respect to the foreign ones. The exchange rate signifies a conversion factor which is nothing but a multiplier of ratio but it depends on the particular direction of a simple conversion. Sometimes, the price is also called as the exchange rate. It is called as the price but with a slightly different perspective as to the ration factors. It is stated that if the exchange rate is highly dynamic and can move very freely, then the exchange rate will automatically turn out to better and really faster with the price of the economy. As a result, it will bring out all the foreign goods together in one. A good example of exchange rate is: Let’s take it as one US Dollar is equal to 10,000 Indian rupees, then the exchange rate will be 10,000 rupees to one US Dollar. So, if a product or a service costs 50,000 rupees then the conversion of it in US Dollar will be 5 US Dollars. It is automatically converted as a matter of accounting. Higher the number, higher the conversion factor and ratio.

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What are the different exchange rate measurements?

There are some tools of operation which can be used in measuring the exchange rate, these are:

1. Spot Exchange rate

The spot exchange rate is basically the rate for a specified and elaborated currency which stands at today’s market prices. In simpler words, it is the price which is relatively same with the exchange of one currency for the other currency. It is an immediate delivery of exchanges. The pot exchange rates mainly represents the prices, which the buyers offer in one particular currency for a purchasing process in a different currency. Also the spot exchange rate is mainly for the purpose of the delivery within the earliest notice value date. It affiliates the standard settlement date for the purpose and study of most of the spot currency transactions which are made within the period of two business days after the actual transaction date.

2. Forward Exchange rate

The forward exchange rate is the rate, as the name suggests involves the ongoing process of delivering the prominent currency at a much specified period of time in an estimated future at an agreed rate. The companies which are desperate to cover for these rates tend to reap the future benefits for a longer run. Companies which wants to reduce the risks ranging from the exchange rate volatility can buy the desired currency charge to the forward place the desired as well as the target market. The forward exchange rate is an important rate which is applicable with the financial transactions which are going to take place in the near future. Hence, high future predictability is needed. The spot rates are the main originators of the spot rates. These spot rates are adjusted for the convenience of forward exchange rate for the cost of carry and also the referral to the rate which will be used further to deliver the desired currency charge or even a bond. The forward exchange rate also refers to the rate which is fixed for a specific future time period for a future financial obligation which it holds, such as the interest rate to be paid on the loan payment.

3. Real Exchange rate

This is the most basic and most used exchange rate tool used. The real exchange rate comprises of the rate of the domestic price which is indices between two different counties at a specific period of time. The state of increase in the real exchange rate implies that the competitiveness of the particular country is getting bad by rate by rate. Real exchange rates are basically the nominal exchange rates which are corrected by the appropriate inflation measures which are being taken in consideration. It is in the simpler terms the weighted average rate of a particular country’s currency value which is relative to the index or the basket of the other currencies which is rightly adjusted for the sublime effects of inflation and deflation. This weighted average exchange rate is determined by firstly comparing the relative trade code balance of the currency of the country against the currencies of other countries within the specified index. The following exchange rate is mainly used for determination of a single particular country’s currency value which is seen as relative with the other prominent currencies featured in the index. It includes the Japanese Yen, Euro and US Dollar.

What do you mean by Business cycle behavior?

The business cycle refers to a situation, when too many element effecting the exchange rate work are working for the purpose of exhibiting the clearly defined cycle behavior of business. It is stretched to the very extent when the exchange rate is fully determined by the off-going trade balance which is occurring in the target market. The exchange rate is actually counter-cyclical which as same as the latter. At the very peak of the upgrade, the trade deficit automatically would lower down the exchange rate which will result in the depreciation of the exchange rate. And as a consequence, if the autonomous dynamics in the foreign exchange in the market are being compiled as the main factors of the exchange rate, then the rational rates will intense the usual micro-fluctuations and as a result the long term tides would ride the irreversible exchange rate which will result possibly with the help of the central bank’s timely interventions.

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Exchange Rate Determination

Exchange Rate Systems

Exchange rate is the price of one currency in terms of other currency. It is the amount of one currency which exchanged for other currency. Currencies are continuously traded in the foreign exchange market and the prices are determined with the changes the supply and demand.

Exchange rate index measures the value of a currency against a trade weighted basket of currencies and the emphasis given to each currency depends upon the share of transactions completed with the country.

Exchange rates characterize the cost to firms because of the commission paid on the exchange of one currency for another. When exchange rate changes, it creates a risk to those firms that hold assets in currencies other than domestic currency. Exchange rate also affect price of exports and imports and thus, affecting the aggregate demand and balance of payments.

An exchange rate is influenced by many causes such as interest rates, confidence among the people, balance of payments on current account, economic growth and relative inflation rates etc. When there is an increase in the value of exchange rate then the value of the currency increase and this is known as appreciation and the reverse i.e. decrease in the value of exchange rate is known as depreciation.

An exchange rate regime tells us about the way in which a nation manages its currency in the foreign exchange market and it is closely related to the country’s monetary policy. It is a type of system which determines the exchange rate for specific countries or region or the global economy as a whole. There are three basic types of exchange rate regimes:

1. FREE FLOATING EXCHANGE RATE:

In a free floating exchange rate regime, currencies are allowed to move freely and adjust with the changes in demand and supply. Here, the government has no influence over the exchange rate and it leaves it to the market forces to determine the exchange rate. This is the fluctuating exchange rate which fluctuates in the foreign exchange market.

Economists believe that floating exchange rates are one of the most suitable exchange rate regimes for a country because this system automatically adjusts to prevailing economic conditions. A free-floating exchange rate provides a cushion to insulate the economy from the impact of international dealings i.e. it helps the country to reduce the impact of shocks and foreign business cycles, and tackle balance of payment crisis etc. However, they also provoke unpredictability as the result of its dynamism because fluctuating exchange rates make international transactions riskier and thus increase the cost of doing business with other countries.

Trade flows and capital flows have an effect on the exchange rate under a floating system. This regime reduces the need of foreign exchange reserves and may help to prevent imported inflation. There is a freedom to set the policy interest rates to meet the domestic objectives and there is less risk of a speculative attack. The exchange rate is governed by the market forces i.e. through interactions of banks, firms and other institutions that buy and sell currency for transaction purposes in the foreign exchange market.

A free-floating system is considered as a self-regulating system because the market plays an important rather and here the role of governmental intervention does not exist. Market forces also control large fluctuations in demand or supply and determine the exchange rate accordingly.

2. FIXED EXCHANGE RATE:

In a fixed exchange rate regime, the government keeps the value of a currency at a certain level compared to other currencies. Here, a country’s currency does not vary according to the foreign exchange market. To maintain that fixed value, a country buys and sells large quantities of its currency.

The purpose of a fixed exchange rate system is to retain a country's currency value within a very narrow band i.e. to ensure stability in foreign trade and capital movements. Fixed exchange rates help the government in maintaining low inflation, providing greater certainty for exporters and importers which stimulate trade and investment in the long run. Many developing economies have fixed exchange rate regimes whereas most industrialized nations adopted floating exchange rates since early 1970s.

In fixed exchange rate regime, each country keeps the value of its currency fixed in terms of some external standard such as gold, silver, other precious metal, another country’s currency or even some other unit of account decided by international organizations. For example, gold standard which was the most famous fixed rate system where a unit of currency is pegged to a specific measure of gold. This system is also known as Pegged exchange rate system.

Here, the government has all the power to influence the exchange rates because country's government decides the worth of its currency in terms of either a fixed weight of an asset, another currency, or a basket of other currencies. The central bank of a country also buys and sells currency at the fixed price which creates stability in the economy. Fixed exchange rates avoids currency fluctuations this encourages investment. This regime helps in keeping the level of inflation low. It reduces the costs of currency hedging for businesses and improves the efficiency of firms. It imposes the responsibility on government policies and leads to lower borrowing costs.

However, there may be conflict with other macroeconomic objectives to maintain a fixed level of the exchange rate many and it becomes difficult to respond to temporary shocks i.e. less flexibility. And this type of system can lead to current account imbalances and it limits a central bank's ability to adjust interest rates as needed for economic growth.

3. MANAGED FLOATING EXCHANGE RATE:

In a managed floating exchange rate system, the value of the currency is determined by market demand for and supply of the currency but with some governmental intervention. When governments get engaged in a free floating exchange rate, it is the managed floating exchange rate. It is neither a fixed nor a flexible exchange rate system but a mix of both.

Here, the exchange rate is determined by the market forces but the central bank does influence the exchange rate through intervening in the foreign exchange market by putting restrictions to the fluctuations. The aim is to keep the exchange rate within limits i.e. desired target values.

Governments and central banks increase or decrease their exchange rates by buying or selling their own currencies or, by raising or lowering the interest rates. However, exchange rates are still free to float, but governments try to influence their values. The central bank maintains reserves of foreign exchange to ensure that the exchange rate stays within the targeted value. This is also known as Dirty Floating exchange rate system. There are three types of managed/pegged float exchange rates:

  • Crawling bands: The market value of a national currency is allowed to fluctuate within a range specified by a band of fluctuation and this band is decided by the central bank or international agreements. There are periodic adjustments of the bands and they are determined in accordance to the economic conditions.
  • Pegged with horizontal bands: This type is similar with the above crawling bands but here, the currency is permitted to fluctuate within a larger band of greater than one percent of the currency's value.
  • Crawling pegs: This is system where a fixed value of the currency is frequently revised and adjusted due to market factors and it fluctuates within a band of rates. Depreciation or appreciation of the fixed exchange rate is allowed and this gradual shift of the currency’s par value is done as a substitute to sudden and significant devaluation of the currency.

Exchange Rates and Interest Rates

Real interest rate is one of the most important factors in determining the exchange rates. High real interest rates causes an appreciation in currency and cutting interest rates tends to cause depreciation.

High interest rates means saving in that country gives a better return. Thus, investors move funds to the countries with high interest rates. This phenomenon is known as hot money flows and this is an important short run factor in determining the value of a currency. Thus, with higher interest rates borrowing becomes more expensive and consumers will take out fewer loans resulting less investment and consumer spending. Due to the appreciation of exchange rate, exports become expensive leading to lower export demand, lower aggregate demand and thus, slower growth. Similarly, lower interest rates tend to be unattractive for foreign investment which thus, causes fall in the relative value of the currency.

Hot money flows are the capital flows which changes the exchange rates due to the movement to higher interest rates offering countries. It is profitable for the international investors to move money between different countries with different interest rates. Even small changes in interest rates can make a significant impact on exchange rates. This increased capital mobility means money can be moved easily. However, interest rate is solely not responsible for the change in exchange rates, other determinants like inflation, balance of payments, competitiveness in the economy, speculation about the future etc.

Thus, the demand and supply of currency gets affected with change in interest rates. Also, some currencies are subject to exchange rate restrictions and here, the central banks guided the buying and selling of currency by lowering or raising the interest rates.

Policy Objectives of Exchange Rate

The exchange rate of an economy affects the aggregate demand of the economy through changes in exports and imports. Exchanges rates should decrease to stimulate exports and increased when there is inflationary pressure. Thus, exchange rates are manipulated to control unemployment rates and achieve price stability.

Firstly, during times of high inflation, exchange rates should increase because this reduces the price of imports and works to reduce the inflationary pressure by decreasing the excessive aggregate demand. But, the country should not lose its export competitiveness. This is done to maintain the price stability of the economy because inflation comes down.

Secondly, lowering exchange rates i.e. depreciation will raise the aggregate demand because of higher export demand; this in turn increases the national income. The increase in AD leads to demand pull inflation. Thus, higher aggregate demand means demand for jobs increases, firms hire more workers to meet up the higher demand. Therefore, there is job creation in the economy. Also, as the demand for exports and imports are price elastic, there is a development in the balance of payments which causes inflation. Here, there is less incentive to cut costs because for manufacturers who exports goods have no improvement over their competitiveness and this leads to long term inflation.

Overall, in the long run, a country can enhance its productivity and competitiveness leading to job creation and increased exports demand and this will help in reducing the unemployment problem in the economy and strengthen the exchange rate. On the other side, high unemployment leads to lack of competitiveness which decreases the value of the exchange rate over time.

Thus, both the increase and decrease in exchange rates have opposite effects on price stability and unemployment. And, the government and the central bank should weigh the policy objectives and act accordingly.

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