Exchange rate is defined by finance and economic researchers as the value of one country's currency in comparison to another country's currency. For example, an interbank exchange rate of 200 Japanese yen (JPY, ) to the United States dollar (US$) means that 200 will be traded for one US dollar or that one US dollar will be exchanged for 200. As a result, it can be seen that the price of a dollar in yen is comparable to $1/200. The exchange rates are regulated by the foreign market that is open to several buyers and sellers, and in this market, the currency trading is continuous for 24 hours except during the weekends. The exchange rate is divided into spot exchange rate and forward exchange rate. The spot exchange rate is the current exchange rate, while the forward exchange rate that is quoted for trading today but delivery and payment is on a specific future date. This paper seeks to present the various types of the exchange rate, the determinants of the exchange rates and effects in the shift of the various foreign currency to the reserves to the global economy.
The exchange rates are categorized as either flexible (floating), fixed or pegged floating exchange rates. Most currency rates are determined by the foreign exchange market (forex). Due to this phenomena, the exchange rates continuously vary depending on the anticipation of the currency traders. Forex trading is a global market for buying and selling coins. This market has a lot of similarities with the stock exchange, but they differ in that the forex market the individuals do not take the possession of the currencies in trade, but they are only entitled to the profit that is obtained from the exchange of the various units of currencies.
A fixed exchange rate system which is also known as a pegged exchange rate system is a system whereby most governments struggles to maintain their currency value against a particular currency or the commodity in question. For example, the Chinese government has tried to keep the value the Yuan by pegging to a fixed value of the dollar.
The forex determines the floating exchange rate system; here the exchange rates keep on varying from time to time according to the anticipation of the forex traders. The flexibility may be due to the existence of the factors such the central bank interest rates, the countries level of borrowings and lastly the strength of the economy in particular. In the current currency exchange market, most of the economies have fixed their exchange rate on the flexible or floating exchange rate. Most scholars have advocated for the incompatibility of the fixed exchange rates with the free trade in a situation whereby most economies are pursuing independent national monetary policies. For example, the John Maynard Keynes on his argument on the truck fiscal reforms presented that if the external price level is unstable, it is tough to keep both the price level and the exchange rate stable. Therefore, it is for the financial regulators to choose the best way to go (either to keep price level or the exchange rate stable
The history of the US and UK balance of trade
The balance of trade refers to the difference between the value of goods and services sold by the residents of a particular country to foreigners and the values of the property and services purchased by the foreigners. As per the United States Bureau of Statistics 2017, the commodities and services deficit in the US widened to USD 48.5 billion in January 2017 as compared to 44.3 in February. Hence, being observed as the highest deficit since the year 2012 when the imports jumped by 2.3% due to the effects of the consumer goods. At the same time, the equivalent exports rose at 0.6% which was far much less to counter challenge the exports.
The balance of trade of the United States averaged 13623.90 USD million from 1950 until 2017, reaching a peak of 1946 USD million in 1975 and record low of -67823 USD million in August 2006. According to this observation, it is evident that the United States has been running consistent deficits since 1976 due the large importation of the oil and the consumer products. The major trading partner of the United States is Mexico. The country majorly exports nuclear reactors, boilers, machinery, electrical equipment, vehicles, mineral fuels, and plastics. Again the imports from Mexico and other trading partners include agricultural products and other food stuff.
Table 1: US major import and export partners
Imports
Exports
Country
Value (%)
Country
Value (%)
China
21.5%
Canada
16.6%
Mexico
13.2%
Mexico
15.7%
Japan
13.2%
China
7.7%
Germany
5.5%
Japan
4.2%
Source: CIA world fact book (2016)
Table 2: united States import and export by products category.
Imports
Exports
Product
Value
Product
Value
Agricultural products
4.9%
Industrial supplies
26.8%
Industrial supplies
32.9%
Agricultural products
9.2%
Capital goods
30.4%
Capital goods
49.0%
Consumer goods
31.8%
Consumer goods
15.0%
Crude oil
30.4%
Source: CIA world fact book (2016)
Again the United Kingdom is the third a trading and financial power and the third largest economy after the Germany and France. The region has intensified and mechanized their agricultural sector, producing 60% of the local food needs with less than 2% of the labor force. The region is endorsed with resources such as coal, natural gas, and oil. The primary drivers of the economy are services such as insurance, banking, and the business activities. It is important to note that the region is a major importer of the energy, particularly from the OPEC areas.
The region has witnessed a serious of problems in the global economic trade. For instance, the area experienced a crisis in 2008 due to its large financial sector. The challenge resulted in the falling of the home prices and high consumer debts hence leading to the shutdown of the British economy in mid-2008. In 2010 the government initiated several programs to regulate the economic sector and also manage public debts. Therefore due to the above challenges, the United Kingdom balance of trade deficit remains one of the highest among the G7, standing at 5.1% of the total GDP as at mid-2015. The Britain-based government, therefore, intends to eliminate the deficits by 2020 through fiscal measures such as reducing public spending and welfare benefits.
The US balance of trade and the weighted exchange rates can be compared in the table below. Again a graph presenting the relationship between these two phenomena is also presented.
Table 3: United Kingdom balance of payments (2007-2116)
Year
Trade deficit
Exports
Imports
Trade weighted US $
2007
-705,375
1,653,548
2,358,922
0.97
2008
-708,726
1,841,612
2,550,339
0.935
2009
-383,774
1,583,053
1,966,827
0.988
2010
-494,658
1,853,606
2,348,263
0.953
2011
-548,625
2,127,021
2,675,646
0.909
2012
-536,773
2,218,989
2,755,762
0.935
2013
-461,876
2,293,457
2,755,334
0.945
2014
-490,176
2,376,577
2,866,754
0.975
2015
-500,361
2,261,163
2,761,525
1.097
2016
-500,560
2,212,079
2,712,639
1.148
Source: US bureau of statistics (2016)
Figure 1: a graph of balance of trade against the weighted exchange rate
The relationship between the balance of trade and the weighed exchange is inversely proportional. In that, a higher exchange rate discourages exports and encourages import. For example in the table above the value of exports decreases with an increase in the weighted exchange rate. Again at the time the value of the import increases with an increase in exchange rate. In contrast, this observation stipulates that a higher trade deficit occurs at a lower value of weighted exchange rate due to the effects of the currency depreciation making imports to be valued at a priced at the rate as compared to the exports, the trend is clearly shown in the graph above.
A change in the price internal trade commodity such as the energy prices can affect the balance of commerce positively or negatively, for example, a fall in the price of energy-related products will increase its consumption hence increasing its demand. Since the US is a major importer of energy-related products the value of its currency weaken due to excess outflow of the currency as compared to the local demand
The determiners of the exchange rates and their relevance to the UK and Eurozone.
The determiners of the development of the most world currency reserves lie mostly on the economic and political factors of the global markets. The relationship between exchange rates and economic parameters is very unstable (Anderson, 2016, P. 60) and therefore it is important to consider the relationship between macroeconomic factors and their effects on the interests’ rates. These variables are as discussed below.
The interest rate differentials: the interest rate differentials according to uncovered interest parity (UIP) condition, is the differences between the expected changes in the currency rates between the two countries exchange rates. Most research stipulates that the countries with high-interest rates tend to appreciate against those once with the low-interest rates. In most cases, the short term differential in interest rate between the euro area and the U.S is positively correlated with against the euro and dollar exchange rates. : A great relationship occurs in interest’s rates, inflation, and the exchange rates. For instance, most central banks manipulate the interests to influence policies in correcting inflation and the exchange rates. A higher interests rates attract foreign investors hence, a large capital inflow, translating into an increased exchange rate (Lewis, 1995}. To this end, the growth in the rate of interest should be regularly checked and to avoid unnecessary inflation
Current account and trade balance: current account incorporates both balances of trade and unilateral transfers of funds (Lothian, 2016, p.36). For instance, a current account surplus in the Euro area indicates a greater demand for euros from foreigners to acquire goods and services produced in the region. Therefore, the euro will, therefore, exchange at a higher rate due to the increase in its demand hence reinforcing itself against the U.S dollar price.
The inflation differential: Most scholars observe that the relationship between inflation and exchange rates is not very direct from the theoretical point of view (Anderson, Sweeney & Williams, 2016, p. 120). For instance, an appreciation of the interest rate and a consequent decrease in the prices of the imported goods leads to a fall in the in consumer price inflation (CPI). Again lower inflation rate compared to the foreign partner’s price level will put upward pressure on the exchange rate due to the purchasing power differences. According to (Lothian, 2016, p.90) if the exchange rate is stationary, the bilateral trade should be able to offset any differences in inflation. The decrease in inflation in the euro area, for example, shows that the commodities produced in euro are cheaper about those of the trading partners. Therefore, their demand (goods) will increase and so does the need for the euros, making the value of the euro currency to appreciate. The figure below shows the relationship between the inflation differentials and exchange rate. The correlation is negative suggesting that it has resulted in the appreciation the appreciation in the value of the euro between 2012 and 2014..
Figure 2: Inflation differential and exchange rates
Source: Eurostat and Bureau of Labor Statistics.
The balance of payments theory
The balance of payments is the systematic record of the economic transactions between the residents of the country and the rest of the world over a particular period of time. Indeed to properly understand the concept of the balance of payments a clear distinction must be made between market balance of payments and accounting balance of payments. Gibson and Thirlwall (2016,p.37) present that the market balance of payments encompasses the balance of supply and demand for the countries’ currencies in the forex market at a given the scholars further argues that if the exchange rate is fixed the currencies will balance by chance. Therefore, in this case the monetary authorities must intervene by manipulating the local currencies against the available foreign currencies, whoever, it is very vital to note that the market balance of payments must balance since the exchange rate is the price which equates the supply and demand for the currency in the foreign market.
The accounting balance of payments shows the record of all the balance of payments is the regular record of the economic transactions between the residents of a country and their trading partners over a particular period. Indeed to correctly understand the concept of the balance of payments a clear distinction must be made between the market balance of payments and accounting balance of payments. Gibson and Thirlwall (2016,p.78) present that the market balance of payments encompasses the balance of supply and demand for the countries’ currencies in the forex market at a given the scholars further argues that if the exchange rate is fixed the currencies will balance by chance. Therefore, in this case, the monetary authorities must intervene by manipulating the local currencies against the open exchange, whoever, it is very vital to note that the market balance of payments must balance since the exchange rate is the price which equates the supply and demand for the currency in the foreign market. The accounting balance of payments shows the record of all the monetary transactions in assets, goods, and services while participating in the international trade within the accounting period of one year (Gibson & Thirlwall 2016, p.59).
The theory of the balance of payments states that the price of the foreign exchange is determined by the forces of the free forces of the demand and supply in the money and the commodity market. Hence it is vividly clear that the external strength of the currency lies in the demand and the supply of the currency itself. The forces of the demand and supply are determined by the various factors that influence the exchange rate.
As per the theory, a deficiency in a balance of payments results in the depreciation of the rate of exchange while the surplus in the balance payments boosts the exchange reserves hence leading to the appreciation in the price of the home currency in the global market. To this end, it is clear that a favorable balance of payments leads to an appreciation in the domestic while an unfavorable balance of trade leads to the depreciation of the currency compared to the international currencies.
The spot exchange rate and forward rate computation.
The foreign exchange spot is also referred as the FX spot. It stipulates a commitment between two parties to buy one currency against selling another currency at a predetermined price for settlement on the spot date. Also, the forward exchange rate is the rate at which the financial institutions agrees to exchange one currency for another at a particular rate in the future date. Most organizations enter into forwarding contracts to take advantage of currency hedging. The forward rate is computed comparing the parity relationship among the exchange rate and the differences in the interest’s rates between the currencies of the two affected countries. One-year forward rate between Jan 2016 and December 2017 is computed as a follows.
F = S * ((1 + INTf) / (1 + INTd)).
Where:
INT d is the interest rate in the domestic currency, or the base currency
INT f is the interest rate in the foreign currency, or the quoted currency
F is the forward rate
S is the spot rate.
The forward rate for USD/EUR is equivalent to
F = S * ((1 + INTf) / (1 + INTd)).
F=1.0684((1-0.25)/ (1+0.4225)
F=1.0684=0.563304
Actual exchange rate 1 USD=0.9509 EURO
The forward rate for USD/GBP is equivalent to:
F = S * ((1 + INTf) / (1 + INTd)).
F=1.0684((1-0.25)/ (1+0.50600)
F=1.0684=0.532072
Actual exchange rate 1 USD=0.8101
The above forward rates show that there is a significant disparity in the actual tariffs. For example, the forward rate for USD/EUR is 0.563304 while the real price closes at 0.9509. Therefore, the most institutions take advantage of the difference which comes to a result of hedging. It is critical note that the hedging difference may either be favourable or unfavourable.
Conclusion on the exchange rates
Exchange rates is a major driver of the world global trade. The effects of the exchange rates differences mostly influences a countries imports and exports and hence, the balance of payments. To this end the paper clearly presents that the world currencies are volatile and keeps on changing in value. For the sterling pound used to have a long history of stability against the US dollar until in 2008 when the greater Europe went into economic crisis. During the period the dollar stated to gain strength steadily putting the region balance of trade into a greater crisis.
It is also evident from the above findings that the three economies, US, United Kingdom and Eurozone has not been experiencing a stable terms of trade. The countries have witnessed a severe balance of payments deficits. A vivid example is England which has experienced negative balance of trade since the 2008. Therefore, to control these shortfalls in these economies the economic planners need to come with series of policies that ensures stability in their exports and imports.
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