Understanding the Exchange Rate

As people set borders and created nations to separate and distinguish themselves from others, they created many things that would be specific to their nationality, race, lifestyle, or ethnicity. Currency is one such thing. While the usage of currency in various forms dates back right to the beginning of mankind, it was only later on that people created specific currencies that would be reflective of the nationality a person belongs to. A problem then aroused when people were to travel and find that the currency of their nation does not work in another. That gave rise to Currency Exchange. People would change the currency of their nation to the currency of a different nation so they would have no difficulty in trading or doing business in the nation they were visiting. This gave rise to the need of creating a system where the currency of one nation can be converted to the currency of another in a manner that reflects the value of both nation’s currency and economy. This conversion is called the exchange rate.

Exchange Rate:

The exchange rate is defined as the ratio of a country’s money relative to the money of another country. It frequently changes in small amounts and varies whether you are buying or selling the currency of another country. The exchange rate depends on the usage of certain commodities, mainly gold. The standard set could be different as well, but gold is widely agreed upon. The rates are decided on the Foreign Exchange where the currency is being traded continuously. The foreign exchange is open to a large number of buyers and sellers who are constantly engaged in trading, 5 days a week. The exchange rate of a country heavily depends upon the ration of imports and exports of that country. For example, if a country just imported a large number of goods, the exchange rate will go up, making the imported items expensive for the buyers of that country. Because of the high price of the items, people then start buying less resulting in a decline of the country’s money further. This in turn means that the items of this country in other countries will become cheaper, people will buy more, hence boosting exports in the country. This cycle keeps the exchange rates from fluctuating too much.

Nominal Exchange Rate:

You must be familiar with the concept of inflation. Inflation causes world economies to fluctuate considerably. A nominal exchange rate is one in which the effects of inflation are ignored. The rate is officially marketed and used in banking throughout the world, without including inflation. The nominal exchange rate is a comparison between the currencies of two countries and does not take into consideration the valuation of goods. Another way to put it is that the nominal exchange rate is the unadjusted average for which a country’s currency is exchanged for other currencies. It is the amount required to make a purchase of domestic currency using a foreign currency. The nominal exchange rate is generally used in the study of economics and in formulating policies regarding international trade. If you visit a forex trader in your country, you’ll most probably find them using nominal exchange rates.

Real Exchange Rate:

While the nominal exchange rate refers to currencies only and does not take into account inflation, the real exchange rate refers to commodities or items and takes into consideration the effects of inflation. This means, when you are talking about real exchange rates, you are talking about the relative price of an item in the USA and UK, for example. The pricing of items is set following the economy of the country and is indicative of the rate of inflation in a country. It would be wrong to assume that if the ratio of currencies between 2 countries is 1:2, the price of an item like sugar will also be in the same ration when converted. The price of the item might be 1:2.5, for example, owing to different rates of inflation in both countries. This also means that the rate of an item in one country depends upon 2 factors: the currency exchange rate between the 2 countries, and the price of the item in local currency.

Effective Exchange Rate:

Another quantity which you should know about is the Effective exchange rate. This takes a company’s currency and compares it with a basket of various currencies worldwide. All the trading partners of the country are listed and the currency of those countries is then compared. Another term used for effective exchange rate is the “trade-weighted index” because the “index” or “weight” attached to the currency of a foreign country determines the valuation of the currency in comparison to the local currency. The comparison is therefore not just between two currencies but between the weighted value of a collection of currencies belonging to other countries and reflect the share of a foreign country in the overall trade of a country. So, you can use the effective exchange rate if you are interested in knowing the amount of trade being done with a foreign country and its impact on the overall economy of the country.

In most cases, the effective exchange rate is denoted using a number between 1 and 100. If the number increases with time, it means the local currency is getting stronger when compared to the other currencies being used in that particular region, and if the value of this index decreases, it means the local currency is at a decline in front of the foreign currencies.

What affects Exchange Rates:

Exchange rates depend on multiple factors. You have seen us use the term inflation extensively so far. That is because inflation is one of the major factors affecting exchange rates worldwide. However, there are numerous other factors as well which we will explain in detail.

  1. Inflation Rates

The first in the list, as you may have guessed, is inflation. Inflation has a strong effect on currency exchange rates worldwide. If a country has low inflation, the currency of that country will take a boost and gain on another country’s currency where inflation is strong. If the inflation rate is low in a country, the prices of items increase at a slow rate, keeping the exchange rates, and the economy stable. This results in a gradual increase in the value of the currency. If the inflation rate is high the prices of goods increases at a much higher rate, all the while declining the value of the local currency. This often results in the accumulation of interest as well, which further decreases the value of the currency. More about interest in the next point.

  1. Interest Rate

There is a relation between exchange rates, interest rates, and forex rates. An increase in one affects the other 2. When the interest rate changes, it brings about a change in the dollar rate as well. If the interest rate goes up, the currency of the country increases in its value as the increase in interest rate means the lenders get an improved rate. Because of this, there is more attraction towards foreign capital, subsequently boosting the exchange rates in favor of the country.

  1. Circular Debt

If a government owes a debt, it is difficult for the government to attract foreign investment as well as capital which causes an increase in inflation. As the debt increases, the government finds it more and more difficult to increase revenue, hence starting a cycle of increasing inflation as well as debt. This further depreciates the local currency. This means you will get a low exchange rate while converting the currency of another country to your local currency

  1. A Country’s Balance of Payments

Every country has a current account in which there are all earnings from foreign capital and investment. the balance in the account refers to how well the country is standing financially. It is based on the number of exports and imports made, as well as details about debts. If the account is in deficit due to the high amount of imports, the currency value depreciates. The goal of governments should be to wipe out the current account deficit to increase the value of a local currency

  1. Political Stability

Often overlooked, the political horizon of a country has a very strong effect on the economic conditions of a country. A country that has a politically stable structure also has a relatively stable currency. However, turmoil and inner fighting results in less investment from foreign companies and hence a stark decrease in the value of the local currency. A country with political stability usually has a stable trade policy which allows minimal fluctuations in the valuation of the currency.

Conclusion:

The factors outlined above, all greatly impact the exchange rate and overall value of the local currency. Governments around the world strive to maintain a balance by keeping these factors in check. A sound understanding of Exchange Rates, Nominal Exchange Rates, Real Exchange Rates, and the way the currencies work in general could result in an overall improvement of the economy of a country.

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