Whether you’re planning a trip abroad or making international payments to suppliers, knowing the exchange rate is essential. But it’s a rate that dances to the beat of many different factors.
There are two broad categories of exchange rates: market rates 문화상품권현금화 (which are based on legal markets and can ‘float’) and official exchange rates.
Price of Goods
The price of goods is an important factor in the economy because it affects the demand for products, which in turn influences production levels. The price of goods can be measured in terms of domestic currency or in terms of a foreign currency, depending on the country’s exchange rate system.
In countries with a floating exchange rate regime, exchange rates change constantly on global financial markets, where currencies are traded around the clock. Traders quote prices for foreign currency pairs based on market fundamentals, such as economic growth, interest rates, unemployment and inflation.
In the long run, changes in exchange rates tend to be offset by changes in inflation rates between two countries. This principle, called purchasing power parity, means that a change in the nominal exchange rate between the US dollar and another currency should be offset by an equivalent change in the price of goods and services. However, this principle is not always true in practice.
Purchasing Power Parity (PPP)
Purchasing power parity (PPP) is the theory that once a currency has been converted into another, it should have the same value in both countries. This assumption is based on the law of one price, which states that if there are no transaction costs or trade barriers, prices for a given good should be the same in different locations.
To calculate PPP, economists compare the prices of a set of goods and services in two countries. These goods are chosen to be as similar as possible, and are usually consumer electronics, such as computers and televisions. Some organizations, like the World Bank, report PPP estimates every few years.
PPP calculations differ from market exchange rates, which only consider the relative price levels of traded goods. In contrast, PPP also takes into account the prices of non-traded goods, such as haircuts or taxi rides. This method of conversion avoids the biases in comparisons made using market exchange rates.
Flexible Exchange Rate System
In a flexible exchange rate system, the value of a currency is determined by forces of demand and supply in the foreign exchange market. This allows for greater flexibility for economies compared to fixed rates, which prevent countries from achieving domestic price stability.
The global commodity boom and the financial crises of the 1990s prompted a reconsideration of appropriate exchange rate regimes for small open economies. Advocates of hard pegs argued that they promote economic stability, while supporters of floating regimes asserted that they enable faster adjustment to negative shocks such as terms-of-trade changes.
However, recent empirical evidence suggests that the benefits of a flexible exchange rate system are more nuanced than they might appear at first glance. In a recent paper, Edwards and Levy Yeyati test the theory that flexible exchange rates are superior to fixed-but-adjustable regimes in terms of their ability to cushion terms-of-trade shocks and to smooth their effects on GDP growth.
Fixed Exchange Rate System
Rather than allowing their currency to float freely, countries that use fixed exchange rates set an upper and lower limit for how much their currencies can rise or fall. The central bank is responsible for maintaining the exchange rate at this decided level. This system offers stability and certainty for exporters, investors, and consumers.
However, it can lead to inflation if the rate is too high. Also, a fixed exchange rate limits how much freedom governments have to alter interest rates, which are key tools they can use to manage the economy and achieve other macroeconomic objectives.
Historically, countries that used a fixed exchange rate system pegged their currencies to a commodity like gold or another widely-used currency. Today, some countries still choose to keep their currency pegged to the dollar, while others prefer to tie their currency to the currency of their major trading partners. This is called a ‘hard’ peg. The Bretton Woods international fixed exchange rate system is an example of a ‘hard’ peg.