Understanding Exchange Rates

An Exchange rate is a rate at which one country’s currency can be exchanged with another country’s currency. It is crucial to determine the values of different currencies to one another, which helps countries assess trade and capital flow dynamics. For example, what is the exchange rate of currencies between USD and GBP, i.e., how many GBP can be exchanged for a single USD? As of February 2024, the exchange rate between the two is 0.79 GBP for one dollar. So, the exchange rates are impacted by two factors: domestic and foreign currency value. For a better understanding of exchange rates, both aspects are essential.

Related: How did US dollar became so powerful?

There is an important concept of cross-exchange rates that is worth discussing. In cross-exchange rates, different foreign currency rates are used to infer the exchange value of the domestic currency. For example, if you want to determine USD to GBP exchange but for some reason can’t access it through a direct method, you can convert, let’s say, USD to CAD and then CAD to GBP exchange rates to infer USD to GBP.

Who Decides Exchange Rates?

The exchange rate is a complex mix; a single entity or a single factor does not decide it; instead, many entities and factors must be considered. Understanding exchange rates demands a thorough understanding of the factors and interconnectivity between them.

Related: Most powerful currencies in 2024

For example, market forces like demand and supply of money are essential in determining exchange rates. If the demand for currency is high, its prices usually increases; conversely, increasing the money supply can lead to the currency’s depreciation. Other factors like Inflation, recession, GDP, and government policies also significantly impact the value of a currency’. Additionally, interest rates set by central banks also affect exchange rates because higher interest rates attract foreign capital, leading to increased demand for domestic currency. Geopolitical events, economic policies, and market speculations also influence exchange rates, forcing them to change and adjust constantly. Here, you can live-track exchange rates.

Related: How global economy is going to act in 2024?

Types of Exchange Rates

The three most widely used types of fixed exchange rates are:

1. Floating Exchange Rates

It is an exchange rates system where the prices are determined by foreign rates depending upon the demand and supply of other currencies. This system of floating exchange rates allows free trade of currencies. It restricts the involvement of governments and central banks in controlling exchange rates because it solely depends on market forces. The pound sterling is a good example of a floating currency. However, in some instances, the government might be involved in keeping currency rates favorable for global trade. For example, the US has been consistently alleging China for keeping the Yuan underpriced to gain a competitive advantage for their products worldwide.

An insight into various investment markets

2. Fixed Exchange Rates

It is an exchange rate system in which one country’s currency is fixed or pegged to the currency of another country or a commonly traded commodity like oil so they can trade freely. Most countries link their currencies to the countries they trade the most, like the USD. The issue with fixed exchange rates is that they limit the role of central banks in controlling interest rates. For example, Saudi Riyal (SAR), Kuwaiti Dina (KWD), and 63 other countries have pegged their currencies to the US dollar.

3. Managed Floating Exchange Rates

This exchange rate system is also known as “dirty float.” This system allows the price of a country’s currency to vary depending on market supply and demand. The government or central bank can influence the currency’s stability or value. In this process, the central bank may buy and sell the country’s currency in the foreign market to manage excessive fluctuations or achieve specific economic goals. It is a hybrid of both free-floating currency and pegged currency.

Learn, how do people achieve financial freedom?

Factors Affecting Exchange Rates

Although many tangible and intangible factors influence exchange rates, some factors that have a high impact are:

1. Interest Rate

Exchange rates and interest rates possess a strong correlation. In a country, interest rates are controlled by central banks. So, an increase in interest rates by the central bank attracts foreign investors to the domestic market. This results in the rapid movement of money from a country of lower interest rates to higher interest rates, resulting in a quick return on investment and, consequently, an appreciation of the domestic currency.

Understand the aspects of financial literacy

2. Inflation

There is a strong relationship between the exchange rate and the inflation rate. Let’s say a country has higher inflation than its trading partner; its currency will also depreciate because of a relative decrease in purchasing power to the other country. Investors seek higher returns to compensate for the loss of value caused by inflation, resulting in reduced demand for the currency and exchange rates after the loss. Conversely, a lower inflation rate relative to the other country can increase the currency’s value in foreign markets.

3. Country’s Balance of Trade (Current Account Deficit)

Balance of trade means the variance of one country’s exports to its imports. A country’s balance of trade can also affect the exchange rates. If a country runs on a trade surplus, its currency will appreciate, while if it is running in a trade deficit, its currency will go down (depreciate). A trade surplus means the country exports more than its imports. So, if a country earns more revenue from exports, it will naturally appreciate the currency’s value.

The current account deficit (CAD) is closely related to trade, i.e., exports and imports. If a country is in deficit and its deficit is higher relative to its trading partner, then this results in the weakening of its currency compared to its partner.

Crypto investment guide

4. Market Sentiments and Speculations

It is one of the most important factors concerning the exchange rate. Market sentiments affect supply-demand dynamics for a currency. Negative or positive sentiments about a currency or economy significantly impact a currency’s value. Moreover, the sentiments and speculations about a currency decide an investor’s confidence, substantially affecting the exchange rate. Sentiments in financial markets have a substantial effect on foreign exchange rates. Any geopolitical event, news, or market speculations may cause significant volatility in the exchange rates.

5. Economic Recession

Certain factors affect exchange rates during a recession, like

• During a recession, consumer spending decreases; thus, demand for imports decreases. Reducing imports will help increase the balance of trade and strengthen domestic currency.
• The central banks of countries come into action during a recession. They usually impose lower interest rates to stabilize the country’s economic growth. So, this might affect the exchange rate by influencing the confidence of investors and the attractiveness of holding a currency.
• The foreign direct investment (FDI) generally decreases in economic crisis-ridden countries. The local market becomes less attractive to foreign investors; hence, demand for the local currency decreases, ultimately causing the exchange rates to depreciate.
• Governments must intervene during recession periods to stabilize the economy and exchange rates. Inflation increases and consumer spending declines during recession periods, so governments have to spend more to keep the economy running; this puts downward pressure on the domestic currency.

Other factors like political stability, government debt, public debt, and government intervention can also strongly affect exchange rates.

Is Lower or Higher Exchange Rate Better?

The answer to this question depends on the perspectives of different stakeholders and their specific economic goals ahead. Lower exchange rates are preferable for an exporter as lower exchange rates make goods and services more competitive in the global market. Weak domestic currency can boost foreign buyers’ sales of more domestic goods, boosting exports and economic growth. Conversely, higher exchange rates are preferable for importers because they can buy foreign goods at a lower cost.

Let’s take the case of tourism. A lower exchange rate can attract more tourists by making the country more affordable. In contrast, a high exchange rate has the inverse effect by limiting the number of tourists from countries with low-value currency.

People receiving or sending money to a foreign country prefer a higher exchange rate in the domestic country as it allows for larger transfers or more purchases in the receiving country.

The Bottom Line

The exchange rate plays a vital role in the global economy; it affects trade and investments in different sectors across the globe. Exchange rate fluctuations influence a nation’s competitiveness in international trade, influencing the prices of exports and imports. In addition, the exchange rate is affected by several factors, including interest rates, inflation, market speculation, economic recession, etc. Governments and central banks often intervene in currency markets to stabilize their respective currencies or achieve specific financial objectives, such as promoting exports, controlling inflation, and stabilizing exchange rates. Understanding exchange rates demands understanding all the factors mentioned above and their correlation.