Importance of Exchange Rates

The quotation of a nation's currency in relation to the currencies of other nations is represented by its exchange rate. According to Gabaix and Maggiori (2015), the exchange rate is crucial for a nation's trade since it serves as a conversion factor for the valuation of goods and services in terms of foreign or local currency, depending on the direction of trade. Since it establishes the price at which a nation's goods and services are sold on the market, it can also be referred to as the price of goods on the global market.
Exchange rates control how much merchandise is imported or exported during trade in an economy. Moreover, since the “one price law” requires an identical good or service to have the same price across all markets, the exchange rate of a country, therefore, plays a role in the determination of the demand and supply of a country’s currency, goods, and services in the foreign market.

Appreciation of a Currency

Appreciation of a currency is the increase in the value of a country’s currency. It means that a country pays less of its domestic currency to obtain a given unit of the foreign currency. During appreciation, an importing economy or traders importing goods benefit since they pay less of a domestic currency to acquire the imported goods. Moreover, local consumers enjoy low prices of goods and services due to reducing costs of imported inputs.

According to Gabaix and Maggiori (2015), a currency appreciation increases the value of domestic goods in the foreign market thereby lowering their demand. It’s because foreign traders will have to pay more to acquire the products. A fall in demand reduces the revenue a country collects from exports hence reducing the growth of an economy. Moreover, a fall in demand for domestic products in the foreign market reduces aggregate demand hence lowering growth rate in the long run.

Depreciation of a Currency

Depreciation is the decrease in the value of a country’s currency in the foreign market. A reduction in a country’s currency increases the demand for the products in the international market since foreign traders will pay less for the goods and services. Additionally, importing countries will suffer from the depreciation since they will have to pay more of the domestic currency to acquire imports (Bénétrix, Lane & Shambaugh, 2015). Depreciation may lead to unbalanced budgets since the cost incurred in the importation of foreign products will exceed the revenue collected from exports.

Depreciation of currency will encourage foreign and domestic investments. However, it may discourage domestic consumption due to high costs of production inputs. On the other hand, depreciation of a currency can benefit a country which wants to limit the importation of commodities. Due to increase in the cost of importation, traders will focus on the exportation of the domestic products which are demanded in the foreign market due to the relatively lower prices.

Factors that Impact Exchange Rates in the Long Run

Due to the advancement of international trade, exchange rates act as the price of commodities in the market and therefore are significantly influenced by the powers of demand and supply. In the long run, the following factors will affect the exchange rate of currency in an economy;

Relative prices- The relative price levels in an economy affect the exchange rate of currency. For instance, a fall in the relative prices leads to an appreciation in a currency while a rise in the relative prices leads to depreciation of the currency in the long run (Bénétrix, Lane & Shambaugh, 2015). This because a rise in the relative prices will reduce the demand for the domestic goods or a country’s currency. Due to the market forces, the currency will react to the change by depreciating to stabilize the economy.

Demand for domestic products- Demand for domestic products relative to foreign goods affects the exchange rates. If the demand for a country’s domestic products is higher compared to the demand for foreign or imported goods, then the currency will appreciate (Ricci, Milesi‐Ferretti & Lee, 2013). However, an increase in the demand for foreign products compared to domestic goods causes the currency to depreciate.

Trade barriers- When a country increases its trade restrictions through tariffs and quotas, it will cause the currency to appreciate in the long run.

Level of productivity- The relative productivity and competitiveness of a country to another dictates the exchange rates. When a country is more productive, then its currency appreciates while when it's less productive compared to the other, its currency will depreciate.

How Central Banks Impact Exchange Rates

One of the roles of the central bank of a country controls the quantity of foreign exchange available in the market. To maintain a smooth flow of market transactions, the challenges brought about by the exchange rate volatility must be eliminated. The central bank regulates a country’s exchange rate through moral suasion, direct controls, and interventions.

Direct controls- Through Exchange Control Act, the central bank closely monitors the amount foreign exchange transactions that are reported in the balance of payments (Ricci, Milesi‐Ferretti & Lee, 2013). Transactions relating to exports, imports, repatriation, and other remittances reflect a number of foreign exchange transactions.

Interventions- The central bank buys and sells the foreign exchange to stabilize the exchange rates to reduce its volatility. During depreciation, the bank sells the foreign exchange to increase its supply. Likewise, it buys the foreign exchange rate during appreciation to reduce its supply. Moreover, the central bank may undertake a sterilized intervention like open market operations in the domestic market.

Moral Suasion- The central bank advice the commercial banks on the importance of adhering to the laid down policy requirements to prevent unhealthy speculations and volatility in the exchange rate.

















References

Bénétrix, A. S., Lane, P. R., & Shambaugh, J. C. (2015). International currency exposures, valuation effects and the global financial crisis. Journal of International Economics, 96, S98-S109.

Gabaix, X., & Maggiori, M. (2015). International liquidity and exchange rate dynamics. The Quarterly Journal of Economics, 130(3), 1369-1420.

Ricci, L. A., Milesi‐Ferretti, G. I. A. N., & Lee, J. (2013). Real Exchange Rates and Fundamentals: A Cross‐Country Perspective. Journal of Money, Credit and Banking, 45(5), 845-865.