Impact Of Exchange Rates On The Economy

The government of every country would always appreciate the scenario where they can have a fixed exchange rate as it often does this through its agent the Central Bank, fixes the value of the currency to another currency such as the US dollar or United Kingdom pounds sterling. Official exchange rates are then usually quoted in terms of US dollars or pounds sterling. A good example is the government of Nigeria in the early 80’s when the Federal government had a fixed exchange rate which was fixed with the UK pounds sterling, and then a pound was equal to a Naira. The federal government used the central bank to mob in excesses from circulation so as to achieve its desired result.

Some other countries also had this in place and the same is being worked upon by the European Union with the use of one currency for all countries in the union (EU). The currency used is the Euro. The main interest in such administration is the ability to control and ensure a steady system which would call for a regulated economy.

1.1 OBJECTIVE

The objective of this assignment is to discuss issues which would be mentioned below as they would affect certainty in international trade when all countries adopt a fixed exchange rate. The issues include:

Types of exchange rate

How exchange rate changes

Impact of exchange rate on the economy both nationally and internationally

Understanding of fixed exchange rate from demand and supply perspective.

1.2 DEFINITION OF EXCHANGE RATE

According to investorwords.com (2010), exchange rate is ‘Rate at which one currency may be converted into another. The exchange rate is in use at the time of converting one currency to another of any other country for travelling, business purpose etc. There exist many factors that influence the exchange rate, such as interest rates, inflation, and the state of politics and the economy in each country. This is also known as rate of exchange or foreign exchange rate or currency exchange rate’.

(Reference: http://www.investorwords.com/1806/exchange_rate.html#ixzz19MRPF6yd)

1.3 TYPES OF EXCHANGE RATE

Exchange rate basically has to do with the agreed currency/amount/value that a country would a peg for transactionary motives between its country and other countries around the globe for business motives. The following are the types that exist:

The floating Exchange Rate: This is determined by the market forces of demand and supply. Every currency reveals the value of what the buyers want to pay for it.

The nature of demand and supply in any given market is determined by some expected forces as afore-mentioned above, and as the quest of the consumers drives the factors to determine how much exchange would be fixed, so also is the power of suppliers and their ability to meet up with the requests tendered by the consumers.

Fixed Exchange Rate: A fixed exchange rate is such that is fixed and maintained by the government of a country or by its financial institution like the central bank. This is also regarded as a pegged rate. No fluctuations are allowed in the rate and this is usually fixed along side the US dollar.

Others include:

Spot Rate: This type allows for use of the price for exchange which is determined at that particular time i.e. at that spot. Only few delays occur to this type of exchange rate.

Forward Rate: This rate applies to transactions which come up at determined time in the future. The value of the exchange is fixed at the present period and settled later.

Future Rate: This allows for the transaction to be made now and the price is fixed for a future date.

(Reference: http://ezinearticles.com/?Types-Of-Exchange-Rate—Their-Terms-And-Definition&id=5138506, assessed on the 28/12/10).

2.0 IMPACT OF EXCHANGE RATE ON THE ECONOMY BOTH NATIONALLY AND INTERNATIONALLY WITH UNDERSTANDING OF FIXED EXCHANGE RATE FROM DEMAND AND SUPPLY PERSPECTIVE.

Fixed exchange rate has to do with a country or economy under which the government or central bank fixes the official exchange rate to another country’s currency or the price of valued goods like gold in order to ensure a free flow of transaction between it and the other country(s).  The purpose of a fixed exchange rate system is to maintain a country’s currency value within a very narrow band.  This is also known as pegged exchange rate.

(Reference: http://www.answers.com/topic/fixed-exchange-rate#ixzz19MJnjlGQ)

Fixed rates may provide a more stable environment for international investment and growth through avoidance of uncertainty and associated costs; discipline – incentive to avoid excess demand, inflation, and B of P difficulties; less destabilising speculation. A very simple theory about this is the consideration of the sale of gold. If the price of gold is pegged at the same price for every country, it will ensure that the demand and supply curve of the commodity is fixed and any change in demand will lead to swift change in supply. No matter the quantity demanded or supplied, the price remains as agreed by the countries involved as the exchange rate is pegged. The diagram below makes it more explicit.

From the above diagram, it is evident that any change in the price of the goods or a shift in the supply of the commodity say, gold would mean same price change as there exists a fixed exchange rate policy between the countries.

Appreciation resulting from increase in demand for pounds.

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The diagram below shows an increase in supply S1 – S2. This shows the market value show a downward slope of the exchange rate.

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Source: http://www.investopedia.com/articles/03/020603.asp assessed on 31/12/10

2.1 BENEFITS OF A FIXED RATE

Reduced risk in international trade: This system helps the international market to be confident of the fact that during the course of the trade, there is an assurance of stable price for the commodities.

Introduces discipline in economic management – inflationary issues are less upheld here as the government would want the economy to be competitive and so avoid problems unemployment and balance of payments.

Fixed rates reduce the impact of speculations: This system reduces speculations in the market.

Fixed exchange rate increases business ties: The availability of a fixed exchange rate allows for more businesses to be done by different countries as this would reduce or eliminate fear of inflation or deflation of currency as it may affect the countries considering the impact of import and export.

2.2 DISADVANTAGES OF THE FIXED EXCHANGE RATE

Balance of payments adjustment is not automatic: With a fixed rate, the problem of disequilibrium occurs and would have to be settled through a reduction in the level of aggregate demand. As the level of demand falls consumers take less import, price level falls making you more competitive.

Large holdings of foreign exchange reserves required – This rates require a government to have a large scale reserve of foreign currency to maintain the fixed rate

Freedom loss in your internal policy – Concentration on this might make a government loose focus on other policies for the econmy.

Fixed rates are inherently unstable – Due to rate of inflation, different countries will be affected differently. Countries with low inflation may be very competitive and others with high inflation may not be very competitive.

(Reference: http://www.bized.co.uk/virtual/bank/economics/markets/foreign/further1.htm assessed on 28/12/10)

3.0 CONCLUSION

Fixed exchange rate will allow for a smooth business in the international world when it is allowed to function at its best considering the intervention of the government of each country that are involved. Also to be noted is the fact that if an economy is prone to disturbances from internal causes, there may be advantage in fixed rates as such that it would allow for smooth trade within and internationally.

Countries that have strong and stable economy to accommodate every financial strength would adopt a floating system. Major developed world countries like US, Great Britain, Japan, and Canada.

Also floating rates can absorb the threats of domestic economy shocks occurring abroad and give domestic authorities understanding in seeking joint ways to achieve internal and external objectives.

Therefore, floating exchange rate would give a better chance for smooth, reliable and dependable market ground with perfect market situation which would ensure a better and uninterrupted exchange of goods and commodities.