Currencies power and worth is determined by their exchange rates with other countries. By the end of this article, I hope that you will understand the determinants of a currencies exchange rates and why economies may opt to for overpriced/underpriced currency as a mechanism to promote economic growth.
Types of Exchange Rate:
Fixed: Currencies that have fixed exchange rates mean that rarely deviate and fluctuations and volatility is rare. This may seem rare in modern markets but this can occur for example the Saudi Arabian riyal which has a fixed exchange rate. This can be achieved when the underlying central bank of the country has enough market power to change their market price. In the case of the Saudi Arabian Riyal, its exchange rate with the USD is pegged together and they do this by holding a large supply of USD in their central bank and if the power of local currency were to drop, it would sell its dollar in exchange for its local currency. The process of buying local currency will cause a scarcity in the marketplace increasing price due to the law of demand. Furthermore, the circulation of more dollar in the marketplace as a result of the sold dollar by the central bank will reduce the price of the dollar shifting the price of the local currency back to its fixed position.
Flexible: Flexible exchange rates are currencies who’s central banks and governments don’t actively intervene with the exchange rates of their local currency. Market forces provide determine market price and the government only establish policies to influence the exchange rates rather than directly artificially changing it. Most currencies fit under this category.
3 Factors Affecting Exchange Rates:
The 3 main factors that effect the exchange rates and effectively the power of the local currency are the local interest rates, the financial stability of the country and the money supply of the central government.
The most obvious of the 3 will be the interest rate because investors from foreign countries will be attracted to the prospect of higher interest because they can store local currency in a local bank and accrue more interest overtime in comparison to if they deposited their money in a local bank. However, this ties with the exchange rate and the inflation rate of the local currency because inflation can offset the profit earned from investing money in a foreign country.
The second reason is money supply because if the local central bank is printing large quantities of money and circulating it into the economy, the economy becomes prone to hyperinflation. Although hyperinflation typically only occurs to settle war debts, its effects are visible here in this scenario. With greater currency in circulation, larger prices are bid onto goods artificially raising their prices invoking inflation. As a result, investors will convert local currency into foreign currency if the foreign inflation is low compared to local inflation because they can profit from the inflation.
Finally, financial stability and financial growth of a foreign country exhibit trickling effect on the local currency because investors dealing for local goods and services convert foreign currency to local currency in the process of making the transaction trapping more local currency into the native country leading to a rise in power of the currency.
Undervaluing/ Overvaluing a Currency:
As a result, of the previous knowledge, some currencies can be undervalued if the local economy has been in a war for example since the money supply will need to increase to try settle war debts leading to hyperinflation. Lack of financial stability reduce investors’ confidence in the currency reducing their likelihood of investing. However, examples of currencies exist of countries deliberately undervaluing their local currency such as China. Turkey/ Brazil are both examples of country that had undervalued currencies as a result of war(2013–2019).
Similarly, currencies can be kept overvalued because of high demand from foreign investors the local currency. This can occur when central government increase internal interest rates creating incentive for foreign investors to diversify to the local currency. Examples of this occur in emerging currencies.
Advantages of Undervaluation:
- The local economy is boosted because foreign currencies are more powerful leading to a large amount of the local currency being made from a small quantity of foreign currency. As a result, exports from the country increase as a result of this.
- FDI becomes more attractive because the power of foreign currency means that firms can buy more land in the countries with undervalues currencies.
- The local economy and economic growth is promoted because of the high levels of consumption of the economy.
- Local firms are protected from foreign competition because the undervalued local currency mean that foreign products are overpriced.
- The increased FDI creates new jobs in the local country promoting further economic growth
Disadvantages of Undervaluation:
- The lack of foreign competition reduce competitiveness in the local country and therefore puts less pressure on firms to operate efficiently and optimally.
- For a country with a limited labour supply, the increasing demand for jobs creating from foreign firms establishing in the country paired with reducing labour force means that wages for labour increases which leads to inflation. This has begun to occur in china after the one child policy had its full effect on the economy.
Advantages Of Overvaluation:
- For a country which is dependant on its imports from emerging countries for goods and services, an overvalued local currency allows it to afford more foreign currency and therefore afford more of the outstanding good they wish to import.
- An overvalued currency also creates increased political stability to the extent that some imports are handled/subsidised by the local government. The act of devaluing an overpriced currency would increase the cost of the imported good and therefore would cause the population to go into protest. Therefore, devaluing would be detrimental to the ruling regime
- Having overvalued currencies will increase the level of imports which will settle inflationary pressure of the local currency. However, we need to consider that by doing so this will cause increased inflationary pressure on a foreign currency as their demand will increase leading to demand pull inflation.
Disadvantages of Overpricing:
- There is less incentive for foreign firms to export from the country since it is cheaper for them to do so by exporting from a currency that is undervalued.
- Local economy and labour demand will be dampened since foreign exports will seem artificially cheaper compared to manufacturing directly in the local country.
- Reduced FDI from foreign countries because the conversion rates mean that there will be less purchasing power from a foreign currency in the overvalued currency.