The basics
The exchange rate (known also as the FX rate, Forex rate or foreign-exchange rate) between two currencies is the rate at which one currency can be exchanged for another. For example, if you see the US dollar (USD) is at $1.05, this refers to the exchange rate between the USD and another currency (ie the Australian Dollar). In this case $1 AUD will buy you $1.05 USD.
A currency can be either floating or fixed
Floating: Because they are subject to the laws of supply and demand floating currencies are constantly going up and down. The more demand the higher the value against another currency and vice versa. The AUD was fixed until it was floated by Hawke / Keating in 1983 and the wave of deregulation that followed is often credited with giving us a more dynamic, robust economy.
Why float?
The many reasons include:
- thanks to the laws of supply and demand a floating currency automatically adjusts large balance of payments deficits (that’s when there’s a lot more imports than exports). This is because importers are selling lots of that currency to pay people overseas for their goods. This increases the availability of that currency on foreign exchanges which decreases its value. This makes imports more expensive and exports cheaper therefore dealing with the balance of payments problem.
- it frees up interest rates so the RBA can use them to control inflation
- it’s a lot less work for the government.
Fixed: To stop its exchange rate going up and down all the time a country fixes it at a specific rate; this is also called pegging. China has a fixed / pegged currency. A country maintains this by selling lots of its currency to lower the value or by buying lots to increase it – the timeless law of supply and demand. Also, raising interest rates increases demand, and vice versa.
Why fix / peg?
Nations with less sophisticated capital markets and weaker governing institutions tend to fix / peg their currency because it creates a stable atmosphere which encourages foreign investment and therefore prosperity.
How does the value of an exchange rate impact the economy?
The higher a nation’s currency the more expensive its goods and services to people overseas and that’s not good for some businesses. This includes tourism, because it’s more expensive to travel here and the manufacturers / exporters, because their selling price is now higher than those manufacturers / exporters overseas.
So what things affect the value of a currency?
Interest rates
Overseas investors like to buy a currency from a place that has higher interest rates than theirs so they can lend money to people in that country and make a profit from the extra margin offered by the higher rates. In other words, higher rates increase demand, which increases a currency’s value. And vice versa for lower rates because less people want to buy the currency so its value goes down.
Inflation
Inflation eats away at the actual value of a currency so a currency with low inflation lets you buy more. Not surprisingly investors like that so they want to buy that currency which pushes up its value and vice versa.
Strength of the economy
A nation’s currency rises and falls depending on the performance of its economy and the sentiment of its investors. If business activity, employment, and gross domestic product (GDP) are strong then demand for its currency goes up, which pushes up the currency’s value and vice versa.
Level of government debt
High government debt can reduce a currency’s value. The debt stimulates the economy because the government then spends what it has borrowed on bridges, roads and government cars etc. Buying and building these things employs people which stimulates economic activity which can encourage inflation.
Terms of trade
This is a ratio comparing export prices to import prices. Increasing terms of trade reflects a greater demand for that country’s exports, which means more demand for its currency, which increases its value and vice versa.
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