Different countries in the world have different currencies that are used in the exchange of goods and services. The value of goods and services in a country depends on the currency used. However, economists have come up with a measure that attaches the same value to a commodity irrespective of the country where it is sold. This measure is called purchasing power parity and it states that the value of similar commodities should be the same in different countries. For instance, if a pen costs $1 in the United States and the same pen costs 2 Japanese yen, $1 must be equal to two Japanese yen. This relationship is called the exchange rate. The exchange rate shows the value of a currency measured in terms of foreign currencies. In the above example, the exchange of US dollar against Japanese yen is 2. This means that one USD is exchanged for two Japanese yen. Exchange Rate indicates the strength of one economy in relation to others. The exchange rate of a country is not always constant. It changes depending on the prevailing economic conditions.
The objective of this essay is to determine the factors that affect the exchange rate of a currency. We will also discuss the relative advantages of having a weak currency. These two issues are discussed in the paragraphs below.
The exchange rate of a country’s currency against another depends on the level at which the two countries are involved in trade. This is because the exchange rate is mostly affected by the demand and supply of the currency in a country. For instance, the exchange rate of the US dollar against Japanese yen will depend on the supply of Japanese yen in the united state and vice versa. The exchange rate of a currency therefore depends on the factors that affect its demand and supply.
Inflation is one of the factors that determine the exchange rate of one currency against another. Inflation is defines as the general rise in prices of goods and services in the economy. The level of inflation also varies from one country to another and is not constant. A country may have a higher or lower inflation rate than another depending on the economic and political conditions prevailing in that country. If the inflation rate of a country is lower than that of the other country, the increase in prices of commodities in that country is also lower compared to the other country. Its products will be cheaper to the foreigners and this means the demand for that currency will be high. The country’s currency will appreciate to compensate for the relative decline in prices. This will fulfill the principle of purchasing power parity that similar goods have the same value in different countries. For example if UK has lower inflation rate that US, the demand for sterling pounds will increase as UK products will appear cheap to US. The UK will buy less of foreign goods thus increasing the exchange rate of pounds.
The other factor is the existence of different interest rates for different countries. The investors will look for the best interest rates that will give them high returns. Investors have to buy that country’s currency so that they can invest or lend to it. The demand for that currency therefore goes up and the currency starts to appreciate. If UK, for instance, has high interest rate than US, the investors in US will find it profitable to invest in UK. This will increase the demand for sterling pound causing it to appreciate.
The speculators who expect the currency of a certain country to appreciate in future will desire to save their money in terms of that currency. They increase the demand of that currency causing its value to increase.
The other factor is the current account effect or the trade balance effect. If there is a deficit in the current account of a country, the exchange rate will tend to depreciate in that country in order to make its exports cheap. To close the deficit, the country has to devalue its currency in order to export more so as to balance the current account or have more exports than imports. The exchange rate of that currency will therefore go down.
When the government borrows to close budget deficit, there is inflation that occurs. Inflation causes the currency to lose value against other currencies because it reduces the supply of foreign currencies in that country. If the lenders in this case feel that there is high risk of default, they may choose to recover the debt trough open market operations (OMO). If they sell the debt in the open markets of that country, the exchange rate of that country is likely to decline.
According to Foreign exchange consensus forecasts, political and economic stability of a country also plays a big role in determining the exchange rate of that country’s currency. Where there is economic and political stability, more investors are attracted in that country. More investors will increase the demand for that country’s currency and its value.
A weak currency is the one that has relatively low value compared to other currencies. Te exchange rate of such currencies is relatively low. For instance if the exchange rate of steeling pound against US dollar is 1.6, it means the US dollar is weak against the sterling pound. One sterling pound is exchanged for 1.6 US dollars. A weak currency has advantages and disadvantages in the economy of a country. According to Linch, a weak currency benefits the manufacturing sector of the domestic economy. This is because when the currency is weak, the country’s exports appear cheap to the foreigners. The demand for exports increases and the country enjoys current account gains.
When the currency is weak, the current account is also improved. This is because the amount of exports will exceed imports thus causing export gain. A currency can be devalued in order to eliminate current account deficit. This would also close the overall government deficit because national income will be increased.
A weak currency also improves economic and employment growth in the short run. Devaluation of a currency will increase exports demand because they will appear cheap to the foreigners. This will increase production or output level in the economy and labor demand. Employing more labor means more employment opportunities.
The tourism industry is also boosted by a weak currency. This is because travel to that country becomes relatively cheap. For instance, when the US dollar is weak against other currencies like the Canadian dollar, the cost of travel to US from Canada becomes cheap. More tourists will travel to US and the US economy will gain from tourism.
The foreign exchange rate of a currency is the value of a currency expressed in terms of another currency. The exchange rate of a currency is not constant but keeps on changing depending on the economic conditions. It is affected by several factors like speculation, current account among others. A weak currency is beneficial to the economy in several ways discussed above.