change rates can influence the sourcing of funds for businesses, investment in foreign countries as well as the reporting of financial results. The determination of exchange rates is a complex process that has significant economic impact on imports and exports and in turn job growth. The foreign exchange market plays an important role in the determination of the exchange rates. Individuals can use exchange rates not only for investment decisions, but also for lifestyle choices like tourism, relocation and buying consumer products.
Foreign exchange according to the Federal Reserve Bank (FRB) New York, is money denominated in the currency of another nation. The foreign exchange rate is the price of a currency. More specifically it is the number of units of one currency that buys one unit of another currency. This number can change daily. The U.S dollar is considered the base currency or the “fixed” currency. So a exchange rate quote of 100 yen/ $1 would indicate that $1 USD can purchase 100 Japanese yen.
Foreign exchange rates have significant impact on the economy of the country. When the currency of a country weakens, the purchasing power reduces therefore imports suffer, while exports increase. A stronger currency would translate to reduced exports and increase in imports. Companies find it cheaper to invest in countries with weaker currencies because the operational costs are lower. Thus there is an indirect effect on employment. Tourism increases to countries that have weaker currencies because they are more affordable. Thus the exchange rates have dramatic impacts not only on the business sector but also on lifestyle, investments, tourism and inflation.
The International Monetary Fund (IMF) initially established a system of fixed exchange rates for the currency of all member countries as a part of Bretton Woods Agreement. This par value or benchmark value was based on gold and the U.S. dollar, and the dollar was valued at $35 per ounce of gold. Subsequently however the Jamaica Agreement of 1976 eliminated the use of par values and introduced greater exchange rate flexibility. As a part of this flexibility countries were free to peg their exchange rate to another currency or allow the currency rate to float freely responding to market forces. Many of the world currencies have chosen to adopt floating rates with close monitoring from their central banks.
The exchange rates as noted by the FRB New York are affected by a wide range of factors such as: political turmoil, central bank and government policy, inflation, stock market, investment patterns and business cycles. The basic premise of supply and demand however still play the most important role. The demand for a country’s currency is a function of the demand for that country’s goods and services as well as financial assets. The governments and central banks constantly monitor and modify the supply in order to achieve desired exchange rates for their currency.
Purchasing power parity is a well-known financial theory that seeks to define the relationship between currencies. According to this theory the difference in the inflation between two countries would cause the exchange rate to change. The exchange rate of the country with higher inflation would go down.The implication of this theory is that if the domestic inflation is higher than the foreign inflation then the domestic currency is weaker than that of the foreign currency and vice versa.
Interest rate is the other important factor that determines the currency exchange rate. Interest rate also known as the “nominal interest rate” is defined as the actual monetary interest rate that can be earned on an investment. The difference between the nominal interest rates of countries according to the International Fisher Effect theory, can be a predictor for the exchange rate of their currency. The country with lower nominal interest rates would in theory have lower inflation thus implying a stronger currency. Therefore, countries with low nominal rates have higher foreign exchange rates.
By Subha Varadan