Exchange rate: understanding currency fluctuations and their impacts

An exchange rate, also known as a foreign exchange rate or forex rate, is the value of one currency in relation to another currency. It determines how much one currency can be exchanged for another and plays a crucial role in international trade and finance. Understanding exchange rates is vital for businesses, travelers, investors, and policymakers, as fluctuations in exchange rates can significantly impact the cost of goods, services, and investments across borders.

This article will cover the types of exchange rates, how they work, the factors influencing them, and their impact on international trade and the economy. To learn more about the rates, we delve into complex topics such as real exchange rate equilibrium, economic models of exchange rates, and currency manipulation. 

Types of exchange rates

They can be categorized mainly into two types: flexible (floating) rates and fixed (pegged) rates. Understanding these types helps in grasping how currencies interact on the global stage and the implications for international trade, travel, and investment.

Flexible exchange rates

These rates are determined by market forces without direct government or central bank intervention. Their fluctuation is based on supply and demand in the foreign exchange market. 

For instance, the exchange rate between the US dollar (USD) and the Euro (EUR) changes constantly as traders buy and sell these currencies. If there is high demand for USD because of a strong US economy, the value of the USD will rise against the EUR. Conversely, if the US economy weakens, the USD might fall in value compared to the EUR.

Fixed exchange

A fixed exchange rate is when a country’s government or central bank sets and keeps the value of its currency at a specific level compared to another major currency, like the US dollar or the Euro. They do this by actively buying and selling currencies to ensure the exchange rate stays stable.

For example, China’s currency, the Renminbi (RMB), was historically linked to the US dollar. The Chinese government stepped in to keep the exchange rate steady. This helped control inflation and kept trade stable.

Bitcoin and other cryptocurrencies

Cryptocurrencies like Bitcoin have their own exchange rates, which are highly volatile. These rates are influenced by market demand, regulatory news, and technological changes.

In early 2021, the exchange rate for Bitcoin surged dramatically due to increased investor interest and institutional adoption. However, regulatory crackdowns in some countries later caused significant drops in its value.

How exchange rates work?

Exchange rates work by determining how much one currency can be exchanged for another. They are quoted in pairs, such as USD/EUR, where the first currency is the base currency and the second is the quote currency. The rate tells you how much of the quote currency you need to buy one unit of the base currency.

Direct quotation vs. indirect quotation

In the direct quotation method, the exchange rate is quoted as the amount of domestic currency needed to buy one unit of foreign currency. For example, in the US, a direct quote for the EUR might be 1 EUR = 1.10 USD. This means you need 1.10 USD to buy 1 EUR.

The indirect quotation method quotes the exchange rate as the amount of foreign currency needed to buy one unit of domestic currency. For example, using the same currencies, the indirect quote in the Eurozone might be 1 USD = 0.91 EUR, indicating you need 0.91 EUR to buy 1 USD.

Cross rates

Cross rates refer to exchange rates between two currencies that are both quoted against a third currency, often the USD. This is useful when there is no direct exchange rate available for the two currencies. Like, if you have the exchange rates for USD to JPY (Japanese Yen) and USD to GBP (British Pound), you can calculate the exchange rate between JPY and GBP.

Euro conversions

When converting Euros, the process is straightforward: you multiply the amount in EUR by the current exchange rate to get the equivalent amount in the other currency. Like, If you have 100 EUR and the exchange rate is 1 EUR = 1.20 USD, you will get 120 USD.

Factors affecting exchange rates

Exchange rates are influenced by a variety of factors that can cause them to fluctuate. Understanding these factors helps in predicting and analyzing changes in currency values.

Interest rates

Higher interest rates offer lenders a better return on their investments compared to other countries. This attracts foreign capital, increasing the currency value. For example, if the US Federal Reserve raises interest rates, the USD might strengthen as investors seek higher returns in the US.

Inflation rates

Low inflation rates typically increase a currency’s value because the purchasing power increases relative to other currencies with higher inflation. For instance, Japan has had low inflation for years, which often supports a stronger Yen compared to currencies with higher inflation rates.

Government debt

Countries with large amounts of government debt are less attractive to foreign investors due to the risk of inflation and default, leading to a weaker currency. High debt levels in some European countries during the Eurozone crisis led to a weaker Euro.

Political stability

Stable political environments attract foreign investments, boosting currency value. Conversely, political uncertainty can cause a currency to depreciate. Political turmoil in Venezuela has significantly devalued the Bolivar.

Export or import activities

A country with strong export activities typically has a stronger currency because foreign buyers need to purchase the country’s currency to pay for the goods.

For example, Germany’s robust export sector helps support a strong Euro.

Recession

During a recession, a country’s currency may weaken due to reduced interest rates and a lack of investment opportunities. The USD weakened during the 2008 financial crisis due to the economic downturn and lower interest rates.

Speculation

Market speculation can cause currencies to fluctuate as traders buy and sell based on predictions of future movements. For instance, If traders believe the British pound will rise due to Brexit negotiations, they might buy GBP, driving up its value.

How exchange rates affect the economy?

Fluctuating exchange rates affect various aspects of the economy. Understanding these causes and impacts is crucial for businesses, policymakers, and individuals engaged in international activities.

• A stronger currency makes exports more expensive and imports cheaper, potentially leading to a trade deficit, while a weaker currency can boost exports but make imports more costly. 
• Inflation is also influenced by the changes in rates. A weaker currency can lead to higher import prices, contributing to inflation, whereas a stronger currency can lower import costs and help control inflation. 
• Changes in currency rates also influence investment flows. Investors move their money across borders seeking higher returns and lower risks, based on what they expect from exchange rates. Consumer spending is affected too, as shifts in exchange rates change how much consumers can buy when they travel or shop internationally.

How exchange rates affect  international trade?

Exchange rates have a profound effect on international trade by influencing the relative prices of goods and services between countries. These impacts can affect businesses, consumers, and the overall economy.

Effect on supply and demand of goods

When a country’s currency strengthens, its goods and services become more expensive for foreign buyers. This can lead to a decrease in exports as foreign consumers opt for cheaper alternatives from other countries. Conversely, a weaker currency makes a country’s exports cheaper and more competitive in the global market, boosting demand.

For example, if the Japanese Yen appreciates against the USD, Japanese cars become more expensive for American buyers. This could result in lower sales of Japanese cars in the US. On the other hand, if the Yen depreciates, Japanese cars become cheaper, potentially increasing their sales in the US market.

Effect on businesses

For businesses, exporters gain from a weaker domestic currency because their products become cheaper and more competitive abroad. On the other hand, a stronger currency can hurt exporters by making their goods more expensive in foreign markets. Importers benefit from a stronger domestic currency as it lowers the cost of imported materials or products, while a weaker currency raises import costs, which can squeeze profit margins.

Effect on consumers

For consumers, a strong domestic currency increases purchasing power, making it cheaper to buy imported goods and travel abroad. Conversely, a weak currency reduces purchasing power, making imported goods and foreign travel more expensive. Exchange rate fluctuations also impact inflation; a weaker currency can raise the cost of imported goods, leading to higher inflation, while a stronger currency can help control inflation by lowering import prices.

How to check the exchange rate?

Checking the exchange rate is essential for anyone involved in international trade, travel, or investment. It helps in making informed decisions about currency conversion, international transactions, and travel expenses. 

Reliable sources for exchange rates

Banks and financial institutions often provide exchange rate information for their customers, both online and in branches. These rates can be useful for transactions involving currency conversion. 

• Foreign exchange (forex) market websites, such as XE.com and OANDA, offer real-time exchange rate information.
• Central banks, like the Federal Reserve and the European Central Bank, publish official exchange rates and economic data.
• Financial news outlets, such as Bloomberg and Reuters, also offer exchange rate information as part of their financial news coverage.

Using online tools and apps

Many online tools and mobile apps can help you check exchange rates quickly and easily. 

• Currency converter websites, like XE.com, offer simple tools to convert amounts between different currencies using current exchange rates. 
• Mobile apps, such as XE Currency and Currency Converter Plus, provide exchange rate information and currency conversion tools on your smartphone.
• Additionally, a quick Google search for “USD to EUR exchange rate” will provide the latest rate directly in the search results, making it easy to find current rates without visiting specific websites. 

Real exchange rate equilibrium

The real exchange rate adjusts the nominal exchange rate by accounting for price differences between countries. It shows the true value of a currency based on the goods and services it can purchase. For example, if a Big Mac costs $5 in the US and €4 in the Eurozone, the real exchange rate compares these prices to evaluate purchasing power parity (PPP).

Understanding the real exchange rate equilibrium helps policymakers and economists determine if a currency is overvalued or undervalued. This information can influence economic policies and international trade strategies.

Methods to measure and adjust the equilibrium

Purchasing Power Parity (PPP)

PPP is a theory that in the long run, exchange rates should adjust so that identical goods cost the same in different countries when priced in a common currency. 

According to PPP, if a basket of goods costs $100 in the US and €90 in the Eurozone, the exchange rate should adjust to make $100 equal to €90.

Balassa-Samuelson Effect

This theory suggests that countries with higher productivity growth will see their real exchange rate appreciate. It accounts for differences in productivity between tradable and non-tradable sectors. 

For example, if Germany experiences higher productivity growth in manufacturing compared to the US, the Euro might appreciate in real terms against the USD.

Economic models of exchange rates

Economists use various models to explain and predict exchange rate movements. These models incorporate different economic factors and theories. These models provide frameworks for understanding the complex dynamics of exchange rates, helping investors, policymakers, and businesses make informed decisions.

Uncovered interest rate parity model

The uncovered interest rate parity (UIP) model suggests that the difference in interest rates between two countries is equal to the expected change in exchange rates between their currencies. It assumes no arbitrage opportunities, meaning investors should not earn higher returns by moving capital between countries.

Balance of payments model

This model states that a country’s exchange rate is influenced by its current account and capital account balances. A surplus in the current account (more exports than imports) leads to an appreciation of the country’s currency, while a deficit causes depreciation. Similarly, a surplus in the capital account (more foreign investment) strengthens the currency, and a deficit weakens it.

Asset market model

The asset market model views currencies as assets and emphasizes the role of financial markets in determining exchange rates. It considers factors such as investor expectations, risk tolerance, and portfolio diversification. Changes in economic indicators, such as GDP growth, inflation, and political stability, influence investor sentiment and thus affect currency values.

Manipulation of exchange rates

Manipulation of exchange rates means a country’s government or central bank changes the value of its currency on purpose. 

What ways do they use for manipulation?

Buying and selling currency

The central bank can buy its own currency to make it stronger or sell it to make it weaker. This direct intervention in the foreign exchange market can shift the supply and demand balance, affecting the currency’s value.

Setting interest rates

By raising or lowering interest rates, the central bank can influence the currency’s value. Higher interest rates attract foreign investors looking for better returns, increasing demand for the currency and making it stronger. Lower interest rates do the opposite.

Foreign exchange reserves

Countries hold reserves of foreign currencies. By using these reserves to buy or sell their own currency, they can influence its value. For example, selling foreign currency reserves to buy their own currency can strengthen it.

Capital controls

Governments can implement measures that control the flow of money into and out of the country. Restrictions on how much money can be exchanged or moved across borders can impact the currency’s value.

Public statements and policies

Sometimes, even announcing intentions or making policy changes can influence exchange rates. Investors and traders react to these signals, which can cause currency values to move.

Goals of manipulating exchange rates

Boosting exports

A weaker currency makes a country’s goods cheaper for foreign buyers, which can increase exports and support economic growth.

Controlling inflation

A stronger currency can make imported goods cheaper, helping to control inflation by reducing the cost of goods and services.

Supporting economic stability

Sometimes, maintaining a stable exchange rate is crucial for economic confidence and preventing market volatility.

However, manipulation of exchange rates can lead to tensions with other countries, especially if they feel the manipulation gives an unfair trade advantage. It can also lead to retaliatory measures and trade disputes.

How to combat currency manipulation?

To combat currency manipulation, international organizations and agreements set rules. The International Monetary Fund (IMF) checks if countries’ exchange rate policies support global economic stability. Trade agreements, like those under the World Trade Organization (WTO), include rules to prevent unfair currency practices.

Governments also have their own policies to stop manipulation. They may require transparency in foreign exchange operations and follow market-determined exchange rates. These measures help ensure fair competition and economic stability by reducing currency manipulation and making global trade more predictable.

FAQs

What is an exchange rate?

 An exchange rate is the value of one currency in relation to another currency. It determines how much of one currency can be exchanged for another.

What is Forex?

Forex, or the foreign exchange market, is a global decentralized market where currencies are traded. It is the largest and most liquid financial market in the world.

What is a restricted currency?

 A restricted currency is one that cannot be freely traded on the foreign exchange market due to government regulations. These currencies are usually subject to strict exchange controls and can only be traded within certain limits.

What are cross rates?

Cross rates refer to exchange rates between two currencies that are both quoted against a third currency, often the USD. They help determine the relative value of two non-USD currencies.

What is the difference between fixed and flexible exchange rates?

Fixed exchange rates are set and maintained by a government or central bank, while flexible exchange rates fluctuate based on market supply and demand.