Exchange Rates And Their Role In International Trade Economics Essay

For a country exchange rate plays a major role in its economy. In this paper we will discuss about various exchange rates and how it is helpful in international trade. We will also discuss the differences in various exchange rates and find a solution whether all nations should adopt a fixed exchange rate or not?

Introduction:

An exchange rate is a rate at which one countries currency can be traded in another foreign countries currency. There could be many reasons for which countries have fixed exchange rate such as

Rate of inflation between both the countries

The interest rates of both the countries

Demand and supply between both the countries

Government interventions in exchange market.

Fixed exchange rate:

The rate at which a countries currency is matched with another countries currency or a group of currencies or a standard such as gold. This is also called as pegged exchange rate. By pegging two currencies together it is easy for trades and investments. It can also help to control inflation for a country.

There are several theories involved in the exchange rate system such

Purchasing power parity(PPP)

Interest rate parity(IRP)

International fisher effect(IFE)

Let us now discuss about each of these theories in detail

The purchasing power parity (PPP) focuses on the inflation of exchange rate relationships. There are two types of PPP called as absolute and relative purchasing power parity. The absolute PPP we can see that the exchange rates between currencies of two countries is equal to ratio of prices in both the countries for example if a product A has price X in a country, then the price in country B must also be the same.

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The relative PPP exchange rates over a period of time should be proportional to the changes in price over the same time period. This theory accepts that the prices of the product will not necessarily be the same in different countries when measured with a common currency.

If we want graphically analyze then on the x-axis the depreciation in foreign currency is taken and on y-axis the home currency is taken. This measures the percentage which says inflation is higher or lower.

The interest rate parity (IRP) says that the forward rate of one country with respect to another has a premium or a discount which can be determined by different interest rates between the both the countries.

In the international fisher effect (IFE) the spot rate of one currency will change in accordance to interest rates of the both the countries. It is closely related with PPP because the interest rates are purely correlated with inflation rates.

Floating exchange rate:

This is another kind of exchange rate where the currency valued is always fluctuating and is not constant always. The currency which uses this kind of exchange is called as floating currency. This kind of exchange rate is not used by all countries as the currency is not stable and there are many problems like inflation may be too high.

So, this is a brief discussion about exchange rate and the theories related to the exchange rate.

Part B:

Business certainty in international trade:

International trade is the exchange of goods and services across different countries. Industrialization, transportation, globalization, MNC’s, outsourcing will have a major impact on international trade. International trade is a major source of a country’s economic power. Without international trade the goods and services would not go beyond the borders. International trade is not different from domestic trade, but it has only a few differences like international trade is more costly, trade tariffs, border issues and social factors.

Another difference between domestic and international trades is the production costs and factors. There should be many factors in international trade such as trade restrictions in goods and services. The production costs for any product in a country could be high when compared to another country because of high material costs. For example electronics manufacturing could be costly in UK when compared to china. So both the countries can follow international trade pattern in reducing costs and increasing profits.

Differences between fixed exchange and floating exchange rates:

In a fixed exchange system the government interferes in the exchange market because the present exchange rate is closer to the current currency target. For example when Britain joined the European Union the pound sterling was fixed with EU currency, to maintain the target which sliding by 6% on both the sides the pound could not sustain the selling pressures as a result of which it left the European rate mechanism in 1992. Since autumn 1992 UK had a floating exchange rate.

With floating exchange rates there could be a change in demand and supply. In the above graph of the country. This led to a rise in currency demand which leads to appreciation in market value.

In the above graph we can see that there is a rise in currency supply which also creates problems sometimes. Here the currency supply s1-s2 leads in the depreciation in the market value. So this is a graphical representation of differences between fixed and floating exchange rate.

Pros and Cons of fixed exchange rate:

Pros:

Creates a great stability in international trade since the exchange rates do not change and the investors can do more imports and exports without any depreciation or appreciation.

This helps the producers to minimize their production costs and improve quality and stay as a competition to international markets.

It could decrease inflation and increase the economic growth and international trade in the long run.

Cons:

It has high vulnerability of economic system to speculative attacks.

Government artificially supports the exchange rate system where it could not change the exchange rate of the currency when the country’s economy is efficient.

The interest rates could not change as they depend on the exchange rate so economic growth could be low.

Example of fixed exchange rate:

There is a simple example to explain the fixed exchange rate when there was a financial crisis in Asia in 1997. The Chinese and the Malaysian currencies were in trouble, so the Chinese fixed their currency and Malays pegged their currency to US dollar which helped them to revive their economic fortunes. The countries which adopt fixed exchange regime should be careful about their policies involved. They should have a fair confidence in their international markets or else the entire system could lead to a failure. They need to have a perfect plan when they have moved into the fixed exchange regime. The government will buy currencies of other countries in open financial markets to start the entire process. When the exchange rate goes down the government purchases their own currency with their reserves. These increases in the demand of them own currency and the exchange rate and also the demand for the currency increases. In certain conditions the situation could be unlawful where the government has to sell the currency in a low rate. There could be many reasons like black marketing of currency, so government should take necessary control over this regime like china in 1990 when the government took complete hold over its currency where its currency was fixed to US dollar.

Ought all countries to adopt a fixed exchange rate?

Well, after looking at various scenarios of the various exchange rates we can say that it is good to adopt a fixed exchange rate for all countries as the inflation would be low, there would be increase in economical growth and international trade.

In business the production costs may decrease and the quality increases which would increase international trade. So if all countries have a fixed exchange rate their economic growth would increase and also the exchange rate for their currency would be good.

Conclusion:

With all the factors and examples of various countries into consideration we could say that if the exchange system is fixed or pegged to another country’s currency there would be economic growth and international trade would increase.