UNDERSTANDING EXCHANGE RATES

UNDERSTANDING EXCHANGE RATES

Economic activity is globally unified today to un precedented degree. Changes in one nations economy are rapidly transmitted to that nations trading partners. These fluctuations in economic activity are reflected in fluctuations in currency values.

A freely floating exchange rate regime, in the absence of government interventions. aabsence of government interventions. A devaluations refers to a decrease in the stated par value of pegged currency, whose value is set by the government . an increase in par value is known as revaluation. A floating currency , one whose value is set primarily by market forces. Depreciate is if it loses value and appreciate if it gains value.

An exchange rate is the price of one nation’s currency in terms of another currency, often termed the reference currency. A spot rate is the price at which currencies are traded for immediate delivery; actual settlement takes place two days later. A forward rate is the price at which foreign exchange is quoted for delivery at  a specified future date.

Factors that affect equilibrium exchange rate :

1. Relative inflation rates
2. Relative interest rates
3. Relative economic Growth rates
4. Political and Economic Risk

Although currency values are affected by current events and current supply and demandflows in the foreign exchange market, they also depend on expectationsabout future exchange rate movements.

A central bank is the nations official monetary authority. Because good reputations are slow to build and quick to disappear, many economists recommend that central banks adopt rules for price stability that are verifiable, unambiguous, and enforceable.

Some countries have gone even further and established what is in effect a currency board. Under the currency board system, there is no central bank. Instead, the currency board issues notes and coins that are convertible on demand and at a fixed rate into a foreign reserve currency.

The ultimate commitment to monetary credibility and a currency good as the dollar is dollarization. The complete replacement of the local currency with the US dollar.

No matter which category they fall in, most governments will be tempted to intervere in the foreign exchange market to move the exchange rate to the level consistent with their goals oe beliefs.