Exchange Rate

An exchange rate is the price of one national currency expressed in terms of another national currency. Put another way, the rate of exchange between two currencies, A and B, represents the amount of foreign currency B that can be obtained with one unit of domestic currency A (provided that such transactions are permitted).

International trade necessitates the exchange of currencies since producers will eventually require payment in terms of their national currency. It is for this reason that American producers require payment in dollars, Japanese producers in yen, British producers in pounds sterling, German producers in euros, and so on. Exchange rates and exchange rate markets satisfy this need for currencies and are therefore essential elements of the international-payment system that facilitates the trade of goods and services within the global marketplace.

The international economy has experienced a number of different exchange rate regimes that fall into two broad categories: fixed exchange rates and floating exchange rates. Under a system of fixed exchange rates, the monetary authorities will maintain the value of their currency, in relation to other currencies, at a specific, predetermined rate through the purchase or sale of foreign currency in the foreign exchange market. In contrast, a floating (or flexible) exchange rate refers to a system where the rate of exchange between two national currencies is determined by supply-and-demand forces in the foreign exchange market. There has been much debate regarding the relative merits of these two systems. Since the early 1970s, the major industrialized countries have operated a managed flexible rate system. Through this system, the monetary authorities of different countries do not establish a predetermined rate, but intervene in the foreign exchange market in order offset major, potentially destabilizing, exchange rate fluctuations.

Approaches to understanding the movement of flexible exchange rates have tended to focus on fundamental variables such as national price levels and interest rates. The influence of national price levels is reflected in the notion of purchasing power parity (PPP). This suggests that the rate of exchange between two currencies is equal to the ratio of the prevailing national price levels within these two countries. In other words, exchange rate movements are taken to reflect changes in the rate of inflation in the two countries. Although the relative purchasing power of currencies does serve to explain the trend of exchange rate movements if the inflation differential is large, empirical evidence has demonstrated that it is inadequate as a general model of exchange rate determination. A number of factors—such as speculative capital movements—may cause exchange rates to deviate dramatically from their PPP.

Monetary factors such as capital movements and interest rate differentials have also been seen to play important roles in exchange rate determination. Funds will be transferred from America to Japan, for example, [Page 629]if the rate of interest in Japan is higher than that in America. The influence of such factors becomes complicated, however, since capital movements also reflect expectations regarding future exchange rate movements. Currency volatility therefore arises from market participants continuously adjusting their portfolios in response to evolving short-term and long-term expectations regarding future exchange rate movements. It is for this reason that economics still lacks a complete theory of the forces that determine the rate of exchange.

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