The constantly increasing number of international transactions requires a smooth settlement process, which involves the conversion of one currency to another. The Forex market is primarily designed for this purpose. Nevertheless, the imbalance of supply and demand of currencies on the world stage leads to continuous fluctuations in currency exchange rates.
Thus, the exchange rate is directly linked to economic stability, and the central banks of all countries are closely monitoring the Forex market and take appropriate measures, if necessary, in order to protect the citizens. In this regard, central banks play an important role in establishing the currency by changing interest rates. By increasing the interest rates, the central banks indirectly (through a high return on invested capital) provoke traders to buy the currency of that particular country. However, there are more sophisticated methods used by the central banks to prevent the decline of the economy. Before we consider these methods, it is necessary to understand the basics of the exchange rate mechanism.
Effect of exchange rate on the economy
The exchange rate directly and indirectly affects the following economic: international trade, services sector, technology transfer, and international remittance and capital inflows.
- International trade – the industrial sector can develop only when the country's exchange rate is acceptable. If the exchange rate is unacceptable, the value of goods that can be purchased at the equivalent of each dollar will significantly fall.
- Service sector – the local economy benefits when the exchange rate in the country is stable.
- Technology transfer – a country with a stable exchange rate will have a more favorable market position. In addition, it will be easier to acquire advanced technology, without the outflow of foreign exchange reserves.
- The international remittances and capital inflows – the country with a stable exchange rate will not shirk its debt obligations. Thus, investors will not have any problems in receiving dividends/profits by remittances.
Different ways of expressing the exchange rate
The exchange rate is the value at which the currency of one country shall be converted into the currency of another country. There are various ways of expressing the exchange rates. Namely:
- Normal and actual rate – the rate set by the central bank or the government is called the normal. The rate which is determined by market forces, based on supply and demand, is known as the actual rate. The actual rate revolves around the normal rate.
- The spot rate and the forward rate – the exchange rate at which the currency is currently sold to customers, is called the spot rate. On the other hand, the exchange rate at which the currency will be sold in the future is called a forward rate.
- Selling rate and buying rate – the dealers (banks, financial institutions), working in the Forex market, offer lower and higher rates. The lower rate is the rate of purchase, while the higher rate is the selling rate (Bid/Ask).
- Favorable and unfavorable exchange rates – If the exchange rate increases in relation to the currency of another country, then it is called favorable, and vice versa.
- Fixed and floating exchange rates – If the exchange rate is artificially maintained at a certain level by the central bank and the government, then it is a fixed rate. If the rate is driven by market forces (supply/demand) and fluctuates, then it is a floating rate.
How the exchange rate is established?
- Mint parity theory – the theory is based on the gold standard. In a country that respects the gold exchange standard, the currency will also be indicated in gold equivalent, or in other words, it will be convertible into gold at a fixed rate. In addition, the currency will also have a fixed ratio factor (mint parity and monetary parity) with the currency of another country, respectful of the gold exchange standard. However, today the gold exchange standard is not respected by any country. Thus, the theory of monetary parity has lost its significance.
- The theory of purchasing power parity – for the first time the theory was formulated and launched in a presentable form by the Swedish economist, Gustav Cassel, in 1922. It states that the exchange rate of two currencies must match the ratio of domestic purchasing power. Based on the theory, it can be concluded that the price increase in the country reduces the value (or purchasing power) of its currency. Despite the fact that the theory can be applied in relation to all currencies, it does not take into account other external factors (speculative activity, the inflow/outflow of capital, etc.) that affect the exchange rate.
- The theory of supply and demand – according to the modern theory, which is currently considered to be the accepted as a standard, the exchange rate is equal to the supply and demand of the foreign currency. In addition, the exchange rate is a price point that sets the balance between supply and demand forces.
Why the exchange rates are changing so often?
A number of factors affect the volatility of the exchange rate. Here they are:
- The gradual or sudden change in the scenario of demand and supply of foreign currency.
- Changes in the volume of imports and exports.
- Changes in monetary policy.
- The inflow and outflow of capital from industry, stock market, etc.
- Changes in economic conditions (inflation, deflation)
- Geopolitical changes.
- Changes in the banking sector.
- The increase or decrease in the average income per family will indirectly contribute to a change in exchange rates.
- The general sentiment.
- The activities of speculators.
- Huge technological advances will gradually influence the exchange rate in a positive way.
The essence of the currency control
The exchange rate control implies a process of limiting foreign exchange transactions by the government or the central bank. When the currency control comes into force, market forces cannot operate freely because of the imposed restrictions. Thus, the exchange rate will be different from the rate set on the free foreign exchange market. As a rule, a fragile economy establishes exchange controls. This is done in order to achieve economic stability.
Advantages of the exchange control:
- The achievement of exchange rate stability.
- It allows you to correct the situation of passive balance of payments.
- It prevents depletion of reserves (gold and currency).
- It prevents the outflow of capital.
- It is the basis for economic growth and stability.
Disadvantages of currency control
- Indirectly increases the level of government corruption.
- There should be a great number of competent officials to ensure the smooth functioning of the economy.
- It leads to confusion from the major economic powers.
- Multinational companies do not want to commit themselves.
- The volume of international trade as a whole is reduced.
History has proven that only countries with liberalized exchange control mechanisms will be able to prevent financial difficulties in the early stages and have significant growth. Ultimately, the nature of the human being has gone far from any kind of restrictions, and the currency is no exception.