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Exchange Rate and its Components

Exchange rate is the price of one country’s currency expressed in another country’s currency. There are several types of exchange rates depending on :

  • the regulation: fixed, "floating" (depending on demand and supply) and flexible exchange rate (hovering inside a certain corridor).
  • the market type: spot and forward exchange rates.

At the first glance, it seems that the exchange rate is a mere currency conversion rate determined by supply and demand. However, the exchange rate value is mainly determined by the purchasing power of currencies expressing the national average prices of goods, services, and investments. This economic category characterizes the commodity production and reflects its relations with the global market. Considering that the value is a broad concept expressing the economic conditions of goods production, comparison of national currencies in different countries is based on values prevailing in the production and exchange. Exchange rate allows producers and buyers to compare national prices with prices in other countries. Such a comparison helps to determine whether it is profitable and reasonable to develop a certain type of production in the country or not. Exchange rate completely depends on the law of value and expresses national and global economy ratio.

In the global market, the national goods are evaluated on basis of the international measure of value. Thus, exchange rate contributes greatly to the commodity exchange process in the global economy. Global prices are based on the international production price that, in its turn, is based on prices of the countries supplying the global market with their goods.

Exchange rate:

  • Provides mutual monetary exchange, when trading, capital and credit flow. Exporters exchange foreign currency into national currency since in the territory of their country foreign currency cannot be used as a legal tender. Importers, in their turn, exchange the national currency into foreign currency to buy goods and pay for services. Debtors buy foreign currency to pay off the debt and credit interest.
  • Helps to compare prices of the global and national markets as well as value indicators of different countries expressed in foreign or national currency.
  • Helps to carry out the revaluation of bank or company accounts in foreign currency.

Nominal exchange rate determination is subject to the state involvement and called exchange rate regime. Distinguish between administrative and market-based exchange rate formation mechanisms.

Administrative mechanism refers to a great number of exchange rates, i.e. there are different currencies for different product groups and regions. Administrative mechanism allows decreasing the inflation rate and accumulating gold reserves, therefore, it has the stabilizing effect on the economy during crises. It is just a temporary measure as the economy moves towards normalization and the country shifts to the market-based exchange rate mechanism. This mechanism was used for the first time during the Great Depression in 1929-1933 when the gold standard was abandoned.

Market-based exchange rate mechanism consists of three types of exchange rates:

  • Fixed exchange rate system is a system when all countries have a fixed exchange rate. Each country fixes the value of its national currency without any deviations from the foreign currency. National currencies are usually pegged to EUR or USD. Now inside the Eurozone all the national currencies are pegged to EUR. EU national currencies have fixed exchange rates against EUR.
  • Limited flexibility exchange rate system is a system when countries adjust the exchange rate in compliance with a set of indicators. The example of the limited flexibility exchange rate is the trading band (corridor). Currency corridor system implies the limits for currency fluctuations that are set to stabilize the national currency.
  • More flexible exchange rate system is a system where exchange rates are determined by supply and demand. According to the degree of flexibility, flexible exchange rates fall into three categories: managed floating, independently floating, and adjusted periodically.

What factors affect the exchange rate?

Like any price, the exchange rate deviates from the value basis under the influence of supply and demand depending on different factors. Exchange rate is connected with a great number of economic categories like cost, price, money, payment balance, etc. All factors are closely intertwined and, therefore, it is hard to determine what factor is more important and what factor is less important. Factors affecting the exchange rate are:

  • Inflation Rate

    The exchange rate axis reflecting the law of value is the currency correlation at purchasing power parity level. That is why the inflation rate affects the exchange rate. The inflation rate and the exchange rate are inversely proportional to each other, i.e. the decrease of the inflation rate leads to the increase of the national currency rate, and vice versa. Money depreciation caused by the decrease of the purchasing power makes the national currency rate lower against currencies of those countries where the inflation rate is not so high. This tendency is observed in medium-term and long-term planning. It takes about two years to align and adjust the exchange rate to the purchasing power parity since it is impossible to adjust the exchange rate to the purchasing power parity on the daily basis and since there are many other factors that affect the exchange rate.

  • Balance of Payments

    The balance of payments directly affects the exchange rate. The active balance of payments improves the national currency as the foreign debtors’ demand increases. The passive balance of payments decreases the value of the national currency since the domestic debtors try to discharge their immediate external obligations selling their goods and services in the foreign currency. The impact of the balance of payments on the exchange rate depends on the degree of economic openness: the higher economic openness (share of gross national product), the higher elasticity of the exchange rate. Economic policy plays a very important role in the management of the balance of payments: capital accounts and current accounts. Amount of fees, sales quotas, import restrictions, export subsidiaries as well as many other factors have an impact on the balance of trade. Trade surplus increases the demand on the national currency and, thus, enhances its exchange rate, while the trade deficit decreases the demand on the national currency and, thus, reduces its exchange rate. Domestic interest rates, import/export encouragement or restrictions affect the capital flow. The national currency depends greatly on the changes in the capital flow that has the same direction as the balance of trade. However, there is a negative influence of the excessive short-term capital inflow to the country. The excessive short-term capital inflow can increase the money supply that, in its turn, can lead to the currency depreciation and higher prices.

  • The Difference in Interest Rates in Different Countries

    There are two reasons why the difference in the interest rates influences the exchange rate. The first reason is that the difference in the interest rates influences the international short-term capital flows. The increase of the interest rates stimulates the inflow of the foreign capital, while the decrease of the interest rates causes the outflow of the capital, including national one. For this reason, the capital moves to the countries with higher interest rates and the currency value in such countries increases. The speculative money flow increases the balance of payments instability. The second reason is that the difference in the interest rates influences the foreign exchange market and the loan capital market. Executing transactions, banks always take into account the difference in interest rates on the global and national capital markets. The main aim of the banks is to get low interest loans abroad and, then, offer these loans on their own domestic market, but with higher interest rates. However, the nominal increase of domestic interest rates decreases the demand on the national currency since businesses try not to take high interest loans. To take high interest loan means to increase the production cost of goods and, therefore, the price of goods. In such a situation, the national currency devaluates against the foreign currency.

  • Activities of the Foreign Exchange Markets and Currency Speculation

    If the currency rate tends to decline, companies and banks try exchange this currency for another more stable currency, thus, weakening the positions of this currency even more. Forex immediately reacts to the economic and political changes as well as to exchange rate fluctuations. Thus, more opportunities for currency speculation and speculative capital flows appear.

  • Level of Confidence in the National Currency on the Internal and External Markets

    The level of confidence in the national currency depends on the economic and political situation in the country as well as on the aforementioned factors that influence the exchange rate. Not only economic growth, inflation, the purchasing power of currency, supply and demand are considered, but also economic forecasts, inflation forecasts, etc. Sometimes, even waiting for the election results, balance of payments or trade may cause sharp exchange rate fluctuations. Political news, rumors about somebody’s resignation, etc. can cause significant changes in priorities on the currency market.

  • Exchange Rate Policy

    State and market regulation determines the exchange rate. The exchange rate based on the market supply and demand is usually associated with sharp fluctuations. Being an indicator of the state of the economy, currency circulation, money flows, and credit, the real exchange rate is formed on the market. Regulating the national currency, the state fulfills its monetary and economic policy related tasks. Exchange rates fluctuations are connected with the implementation of a certain monetary policy by the state.

  • National Income

    Exchange rate and national income are exposed to the same influencing factors. For example, the supply increasing drives the exchange rate up, while the domestic demand increasing drives the exchange rate down. The higher the long-term national income the country has, the higher the exchange rate will be. However, the relations between the short-term national income and exchange rate are reverse.

  • Market Factors

    Market factors can exert a strong influence on the short-term value of national currency. For example, economic growth forecasts, changes in export and budget deficits, currency market sentiment have a significant effect on the exchange rate. Moreover, the exchange rate is greatly affected by the seasonal decline and upsurge in business activities. For example, at the end of 1996 trading volumes were increasing every day on Moscow Interbank Currency Exchange, as a result, of a long trading interval due to the New Year holidays.