Meaning of Foreign Exchange Rates

Meaning Of Foreign Exchange Rates

When goods and services are exchanged, there has to be determined some rate or exchange ratio between them. In other words, there must be some ‘price’. In the case of domestic exchange of goods and services, the exchange ratios between different goods and services exchanged are determined by taking the ratios of their prices that are determined in the market and are expressed in terms of the domestic currency. The determination of exchange ratios is, however, not so simple when the different commodities exchanged are produced in the different countries having different currencies. Before the ratios of exchange between different goods and services traded between any two countries can be known we must know the exchange rate between the currency units of the two countries. Foreign exchange rates are the links-which connect different national currencies and make international cost and price comparisons possible.

Foreign exchange rate between the currency units of two countries means the number of the units of one national currency that are needed to buy one unit of the other national currency. Either money or currency unit may be used as the unit for expressing the price of the other.

By linking together the currencies or money units of different countries, foreign exchange rates make the comparison of international costs and prices of goods and services possible. Consequently, they play a dominant role in determining the volume and direction of international trade.

Determination Of Foreign Exchange Rate

The foreign exchange rate has been defined either as the price of one unit of reign currency expressed in terms of units of the home currency or as the price of one unit of the home currency expressed in terms of the units of foreign currencies. Like the determination of price of a commodity or service in a free commodity market, the equilibrium foreign exchange rate is also determined in the free foreign exchange market by the demand for and supply of foreign exchange. To make the demand and supply functions of foreign exchange look like the familiar conventional market demand and supply functions we define the rate of exchange as the price of one unit of foreign currency expressed in terms of the units of the home currency.

Demand for Foreign Exchange

The functional relationship between the amount of foreign exchange demanded and the foreign exchange rate is expressed in the demand scheduled for foreign exchange. A demand schedule for foreign exchange is the list or schedule showing the different amounts of foreign exchange demanded at different rates of foreign exchange, ceteris paribus. It follows from the properties of this demand schedule that the amount of foreign exchange demanded and the rate of foreign exchange are inversely related such that a fall in the rate of exchange is followed by an increase in the quantity of foreign exchange demanded and vice versa.

The reason for this inverse relationship is that given the elastic demand for imports, a given percentage increase in exchange rate by making imports costlier reduces the demand for them by a still higher percentage. Consequently, it also reduces the total amount of foreign exchange demanded to pay for imports. On the other hand, a lower (a given percentage fall) rate of exchange by making imports cheaper increases by more than the given percentage fall in the rate of exchange the demand for imports and consequently increases the demand for foreign exchange needed to pay for higher imports. Thus, ordinarily the demand for imports and the quantity of foreign exchange demanded to pay for imports change in the direction opposite to that of changes in the rate of exchange.

 Supply of Foreign Exchange

The supply schedule or curve of foreign exchange shows the different amounts of foreign exchange that are available at different rates of exchange in the foreign exchange market Autonomous components of aggregate supply of foreign exchange are the counterpart of the autonomous components of the aggregate demand for foreign exchange. The sources of supply of foreign exchange appearing on the credit side of the international balance of payments of a country are the exports of goods and services, capital inflows and inward unilateral transfer receipts. These sources of supply of foreign exchange depend largely upon the decisions of foreigners. The total amount of different goods and services which a country can export and, therefore, the total amount of foreign exchange which she can acquire through exports depends upon the quantity of different goods and services which the residents of foreign countries are willing to import from a particular country. The amounts of capital inflows and unilateral transfer receipts depend upon the decisions of the foreign investors to invest in any given country. These decisions are based on the same considerations on which are based the home decisions relating to the movements of domestic capital in the opposite direction. Thus, ceteris paribus, a country’s exports-which are imports of other countries-are a function of the foreign exchange rates because these determine, given their domestic prices, the prices of exports expressed in term of the foreign currencies.

Equilibrium Foreign Exchange Rate:

Having derived the demand and supply curves of foreign exchange, the equilibrium rate of foreign exchange in the free foreign exchange market is determined at the point of intersection of the supply and demand curves for foreign exchange.

 Exchange Rate System:

Exchange rate systems can be classified according to the degree by which exchange rates controlled by the government. Exchange rate systems normally fall into one of the following categories:

  • Fixed
  • Freely floating
  • Managed float
  • Pegged.

Each of these exchange rate systems is discussed in follows:-

Fixed Exchange Rate System:

In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries. If an exchange rate beings to move too much, governments interview to maintain it within the boundaries.

From 1944 to 1971, exchange rates were typically fixed according to a system planned at the Bretton Woods conference (held in Bretton Woods, New hampshire, in 1944) by representatives from various countries. Because this arrangement, known as the Bretton Woods Agreement, lasted from 1944 to 1971, that period is sometimes referred to as the Bretoon Woods era. Each currency was valued in terms of gold.

In December 1971, a conference of representatives from various countries concluded with the Smithsonian Agreement, which called for a devaluation of the U.S. dollar by about 8 percent against other currencies.

By March 1973, most governments of the major countries were no longer attempting to maintain their home currency values within the boundaries established by the Smithsonian Agreement.

Advantages of a fixed exchange rate system. In a fixed exchange rate environment, MNCs may be able to engage in international trade without worrying about the future exchange rate. Consequently, the managerial duties of an MNC are less difficult.

Disadvantages of a Fixed Exchange Rate System. One disadvantage of a fixed exchange rate system is that there is still risk that the government will after the value of a specific currency. Although an MNC is not exposed to continual movements in an exchange, it does face the possibility that its government will devalue or revalue its currency.

A second disadvantage is that from a macro viewpoint, a fixed exchange rate system may make each country more vulnerable to economic conditions in other countries.

 An additional advantage of a freely floating exchange rate system is that a central bank is not required to constantly maintain exchange rates within specified boundaries.

 A freely floating exchange rate system can adversely affect a country that has high unemployment.

Managed Float Exchange Rate System:

The exchange rate system that exists today for some currencies lies somewhere between fixed and freely floating. It resembles the freely floating system in that exchange rates are allowed to fluctuate on a daily basis and there afternoon official -boundaries. It Fs similar to the fixed rates international government can and some­times do intervene to prevent their currencies from moving too far in a certain direction. This type of system is known as a managed float “dirty” float (as opposed a “clean” float where- rates float freely without government inter-venation).

Criticism of a Managed Float System. Some critics suggest that a managed float ”system allows a government to manipulate exchange rates in a manner that can benefit its own country at the expense of others. For example, a government may attempt to weaken its currency to stimulate a stagnant economy. The increased aggregate demand for products that results from-such a policy may reflect a decreased aggregate demand for products in other countries, as the weakened currency attracts foreign demand.

Pegged Exchange Rate System:

Some countries use a pegged exchange rate arrangement, in which their home currency’s value is pegged to a foreign currency or to some unit of account. While the home currency’s value is fixed in terms of the foreign currency (or unit of account) to which it is pegged, it moves in line with that currency against other currencies.

Foreign Exchange Rates