Last Updated on April 9, 2023 by admin
What is foreign exchange rate? Factors that determine the exchange Rate of a country? This content will explain step by step you need to know about a nation’s exchange rate and what helps to determine the rate.
Foreign exchange rate is the price of the domestic currency stated in terms of another currency. This is Conversion rate of one currency into another. This rate depends on the local demand for foreign currencies and their local supply, country’s trade balance, strength of its economy, and other such factors.Foreign exchange rate compares one currency with another to show their relative values.
Since standardized currencies around the world float in value with demand, supply, and consumer confidence, their values change relative to each over time.It is an instruction needed for economic management and it is an important macroeconomic indicator that is used in assessing the overall performance of the economy.A shift in the exchange rate will have effect on certain economic variables such as interest rate ,supply.
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Exchange rate is a strong determinant that is necessary for any economic well being of any nation.In a market friendly environment, exchange rate must respond to the market forces of demand and supply . Exchange rate determination varies from country to country and from one period to another.
What is foreign exchange rate?
Exchange rates tell you how much your currency is worth in a foreign currency. Think of it as the price being charged to purchase that currency. Foreign exchange traders decide the exchange rate for most currencies.
Foreign exchange can be as simple as changing one currency for another at a local bank. It can also involve trading currency on the foreign exchange market.
Foreign exchange is a financial asset usually denominated in foreign [convertible ] currencies . It is an asset earned through export of goods and services as well inflows of foreign investment , external grants and loans from the stock of foreign exchange that a country earns.
It enables countries to meet the financial obligation to the outside world including payment for import of goods and service , repayment of external loans and capital transfer .
The quantum of foreign exchange available at any point in time constitutes foreign exchange resources or reserves .
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External reserves comprise the stock of financial assets available to the monetary authorities to finance temporary imbalance in the external payment position and to pursue other objectives .
Such reserves consist of foreign exchange monetary ,Gold, reserve position in the lint and holdings of Special Drawing Right [SDRS] Foreign exchange is a subset of external reserves, it constitutes the bulk of the reserves.It is the component that is used on a daily basis for settlement of international transactions .
Foreign exchange plays a crucial role in the overall performance of the national economy, the practice of managing foreign exchange resources has evolved broadly in line with the globalization and liberalization of economics and financial markets.
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When trading currencies, they are listed in pairs, such as USD/NGN, EUR/USD, or USD/JPY. These represent the U.S. dollar (USD) versus Nigeria (NGN), the Euro (EUR) versus the USD and the USD versus the Japanese Yen (JPY).etc
Factors that influence Exchange Rate Determination
1. The policy stance of the government-
This is based on the pulse of the economy, especially in the external sector .As well as the need to attain realistic exchange rates which equate the purchasing power parity level.
2. Country’s economic growth and financial stability
This impacts its exchange rates. If the country has a strong, growing economy, then investors will buy its goods and services. They’ll need more of its currency to do so. If the financial stability looks bad, they will be less willing to invest in that country. They want to be sure they will get paid back if they hold government bonds in that currency.
3. Demand and supply-
Any factor that affects the supply at any demand for one currency will affect the rate of exchange of the other trad-able currency. Eg. Change in money supply ,government taxation and expenditure program will affect the domestic currency’s relationship with the trad-able foreign currencies ,that is ,its exchange rate.
4. The interest rate paid by a country’s central bank is a big factor.
The higher interest rate makes that currency more valuable. Investors will exchange their currency for the higher-paying one. They then save it in that country’s bank to receive the higher interest rate.
5. The activities of operators in the foreign exchange market
This involved the market expectations availability of new information and exchange rate consideration ,will affect the behavior of participants in the market,whose unilateral decisions on foreign exchange transaction s when aggregated could affect movement in exchange rate and the value of the domestic currency
countries with lower inflation rates tend to see an appreciation in the value of their currency. Also, foreign goods will be less competitive and so citizens will buy fewer imports.
7. Balance of payments
A deficit on the current account means that the value of imports (of goods and services) is greater than the value of exports. If this is financed by a surplus on the financial/capital account, then this is OK. But a country which struggles to attract enough capital inflows to finance a current account deficit will see a depreciation in the currency.
8. Government Debt
A country with government debt is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their bonds in the open market if the market predicts government debt within a certain country. As a result, a decrease in the value of its exchange rate will follow.
9. Political Stability
A country with sound financial and trade policy does not give any room for uncertainty in the value of its currency. But, a country prone to political confusions may see a depreciation in exchange rates.country with less risk for political turmoil is more attractive to foreign investors, as a result, drawing investment away from other countries with more political and economic stability. Increase in foreign capital, in turn, leads to an appreciation in the value of its domestic currency.
Objective of Foreign Exchange Rate
1. Foreign exchange is held and manage to facilitate international transaction
Consequently, the main objective of exchange rate policy is to have a stable and realistic exchange rate that is in consonance with other macro economic fundamentals. This is because exchange rate instability can have serious adverse effect on prices,investment,and international trade decisions
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2 . A realistic exchange rate policy must be the one that reflects the strength of foreign exchange flow and outflow ,the stock of reserves as well ensuring equilibrium in the balance of payment .That is consistent with the cost and price level of trading partners.
To achieve the above objective the following condition must be adhered to :
I] A country must compelled to shift the policy stance of it’s exchange rate determination as the condition of the economy dictates
Ii] It must be market determinate .i.e they are allowed to attain free market equilibrium levels without government intervention
Iii] Exchange rate may be administratively determined in which case the rate is fixed by flat to one or more convertible currencies without due regard to the appropriate market value