Understanding Foreign Exchange Markets and Exchange Rates

Foreign Exchange Market

The foreign exchange market is a global decentralized market for trading currencies. Like any other market, it operates on the principles of demand, supply, and price.

Nominal Exchange Rate

The exchange rate represents the price of one currency in terms of another. There are two types:

• Direct exchange rate: The cost of one unit of foreign currency is given in units of local currency (e.g., 1 USD = 0.94 EUR).
• Indirect exchange rate: The cost of one unit of local currency is given in units of foreign currency (e.g., 1 EUR = 1.06 USD).

Changes in exchange rates influence relative prices. Currency appreciation occurs when the local currency strengthens, allowing you to buy more foreign currency. This increases the relative price of exports and reduces the relative price of imports. Conversely, currency depreciation weakens the local currency, reducing the relative price of exports and increasing the relative price of imports. Net exporters typically prefer a weak currency, while net importers favor a strong currency for purchasing goods from abroad.

Floating Exchange Rate

In a floating exchange rate system, market forces of demand and supply determine exchange rate movements.

Factors Influencing Exchange Rates

• Differential of inflation: Lower inflation generally leads to currency appreciation as purchasing power increases relative to other currencies. This concept is related to the theory of purchasing power parity, which suggests that exchange rates should equalize purchasing power in different countries. The Big Mac Index is an example of applying this theory by comparing the prices of a standardized product (Big Mac) across countries.
• Arbitrage: Arbitrage opportunities arise when a product can be bought in one market at a lower price and sold in another market at a higher price. This occurs due to market inefficiencies. Arbitrageurs exploit these opportunities by simultaneously buying and selling in different markets, ultimately driving prices towards equilibrium.
• Differential of interest rates: This factor considers financial investments. Carry trade occurs when investors seek higher yields in countries with high-interest rates. However, currency appreciation in the high-interest-rate country can offset the interest rate differential.

Fixed Exchange Rate System

In a fixed exchange rate system, the monetary authority intervenes to maintain a predetermined exchange rate. This system requires significant foreign exchange reserves to manage currency fluctuations.

Pegged with Horizontal Bands

This system allows the exchange rate to fluctuate within a defined band. The central bank intervenes if the exchange rate breaches the upper or lower limits.

Advantages and Disadvantages of Floating Exchange Rates

Advantages:

• Automatic balance of the foreign exchange market and balance of payments.
• Protection against external economic shocks.
• Economic policy can focus on domestic issues rather than external imbalances.
• No interference between external and internal economic policies.

Disadvantages:

• Exchange rate volatility can impact international trade and investment.
• Market adjustments may not always effectively correct external imbalances.

Advantages and Disadvantages of Fixed Exchange Rates

Advantages:

• Exchange rate stability reduces uncertainty for investors.

Disadvantages:

• Requires large foreign exchange reserves to defend the fixed rate.
• Limits the central bank's flexibility in monetary policy.