The exchange rate is an indicator that states the number of units of one currency needed to obtain one unit from another. That is, it is the ratio that exists between the value of the two currencies.
In other words, the exchange rate is the amount that must be paid for a unit of foreign currency and this varies depending on the supply and demand of the foreign exchange market. It is the relationship that exists between two currencies of two countries.
When supply is greater than demand, that is, there is an abundance of dollars in the market and few buyers, the exchange rate falls and rises when the opposite occurs. That is when there is a shortage of dollars and many buyers.
In most countries of the world, the US dollar is used as the reference currency to define the exchange rate in commercial transactions. This currency is used by many countries as a reserve currency and what gives that currency a lot of importance.
The supply and demand for currencies determine the type of exchange rate in the exchange market. These arise from the need to relate the currencies of different countries that is the way for international economic transactions. Within them, we find two types of “nominal” and “real” exchange rates.
1# Nominal change
The “nominal ” exchange rate is the representation of the value of a unit of currency of another country expressed in terms of the national currency. It is a relative price, and its changes also influence the prices of goods and services produced in the country with respect to those produced in another.
- The relative price of the “currency” of the two countries.
- One to which currency is bought or sold in the market.
- The official quotation of the exchange rate.
2# Real change
The ” real ” exchange rate is the price of the goods of the foreign country expressed in terms of local goods. Both carried to the same currency.
If the real exchange rate goes up, national goods will be relatively more expensive and foreign ones cheaper. If, on the contrary, the real exchange falls, national goods will be relatively cheaper and foreigners will then be more expensive.
- It is the price of the “goods” of the two countries.
- It is the purchasing power of a currency over the assets of the two countries.
- Reflects the true purchasing power of the national currency against one or several foreign currencies.
- Represents then, the real purchasing power takes into account the prices of the country of another currency.
These are the policies adopted by a country regarding the value of its currency and determination of the exchange rate or type. Of course, that value, like that of goods and services, can be influenced, and even intervened and arranged, by governments to favor their economy.
An exchange rate regime is based on three types of changes:
- Fixed exchange rate: that refers to the anchoring of one currency to the value of another, but directly and strictly. Monetary policy derives from the main currency. Therefore, changes in their relationship and value are not allowed.
- Flexible exchange rate: when a currency market can produce changes in the value of the currency product of inflation or some commercial activities between several countries. Restrictions may be established to moderate those changes.
- Fluctuating exchange rate: in this mixed system, there may be restrictions, but flexible depending on supply and demand and respecting the established margins that are generally 1% to 3% to help stabilize the exchange market.
Determinants of the exchange rate
The exchange rates are determined by several factors. Some of them are mentioned below.
- Differential inflation: Typically a country with a low inflation rate exhibits a high currency value, as well as an increase in purchasing power relative to other currencies. Countries with high inflation normally depreciate the currency in a manner similar to the currencies of their trading partners.
- Differential interest rate: It is the difference in the interest rate between two currencies. Inflation, the exchange rate, and the interest rate are closely related. When managed by the central bank, the inflation rate and the exchange rate are influenced and the change in the interest rate impacts inflation and the value of the currency.
- Current account deficit: The current account is the balance of the business between a country and its business partners. Payments, interest, assets, dividends, and services are reflected. The deficit is a current account that shows that a country is spending more than it earns and this causes it to borrow.
- Public debt: Countries with large public debt have problems in fulfilling their payment commitment in both the public sector and private debt. Although this stimulates the domestic economy, it is a less attractive country for foreign investment.
Importance of the exchange rate
The exchange rate allows us to compare the prices of goods and services produced in different countries. It also helps determine the actual cost, that is, the amount of money that a thing costs in foreign currency used in international transactions and acquired by the country.
Allows converting the prices expressed in foreign currency into the respective prices of the national currency. It helps determine the value of one currency in terms of another, the exchange rate helps define the health of the nation’s economic system and, therefore, the welfare of the people who reside there.
Finally, trade (import and export) is influenced by exchange rates since most consumers take into account only the price of goods in their own currency.