Exchange rate

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An exchange rate is the price of one currency in terms of another currency. A country’s exchange rate influences, and is influenced by, its balance of payments and its performance in the context of domestic macroeconomics. Exchange rate movements also exert a major influence upon activity in the sphere of international economics.

Definitions

A country’s market exchange rate is the rate that is determined by transactions in the foreign exchange market. Transactions in the foreign exchange spot market take effect immediately, whereas transactions in the forward market take effect in three months’ or six months’ time. The ratio of the forward price of a currency to its spot price indicates the market’s expectation of an appreciation or depreciation of that currency.


A country’s effective or trade-weighted exchange rate is the average of its exchange rates with the those of the countries with which it trades - after each has been multiplied by a weight based upon its relative importance in that country’s trade [1] (For example, the weight assigned to the US dollar in calculating its part in the index for the pound sterling depends upon the importance to UK domestic market imports of imports from the USA and the degree of competition between the UK and the USA in the USA market and in third country markets.) Indexes of the effective exchange rates of the pound sterling, the US dollar and the Euro are published are published monthly by the Bank of England. A rise in a country’s effective exchange rate index is generally taken to indicate a corresponding reduction in its international competitiveness. In calculating a country’s real effective exchange rate index the weight assigned to each country is further adjusted to take account of its general price level relative to that of the original country [2].


A country’s purchasing power parity (PPP) exchange rate is defined as the number of currency units required to buy goods equivalent to what can be bought with one unit of the currency of the base country, usually the US dollar". PPP rates are used in making international comparisons of gross domestic product. A number of international organisations collaborate to provide PPP indexes for member countries [3] [4] using the method of calculation described in an OECD statistics brief [5], and the resulting indexes are published by the OECD [6].

Exchange rate regimes

Fixed exchange rates

As part of the 1944 Bretton Woods Agreement, the signatory countries each agreed to control (or “peg”) the exchange rate of its currency with the United States dollar so as to maintain it within a stipulated band about a fixed level. The United States government, for its part, agreed always to be willing to exchange dollars for gold at the fixed rate of $35 per ounce. The Bretton Woods system was abandoned in 1971 when the United States government cancelled its undertaking to buy gold at a fixed rate. However, a substantial number of countries have continued to peg their currencies to the US dollar.

Floating exchange rates

After 1971, the governments of the majority of developing countries abandoned attempts to control the exchange rates of their countries and have since allowed them to be determined by transactions in the foreign currency market (or, in other words, to “float”)

Hybrid regimes

Among intermediate regimes that have been proposed with a view to maintaining some of the advantages of both fixed and floating regimes was the “crawling peg” proposal that would enable exchange rates to be adjusted at a regulated rate.

Common currencies

The adoption of a common currency among trading neighbours has the advantage of avoiding the adverse consequences of exchange rate fluctuations. Countries that have abandoned their domestic currencies for that purpose include members the Organisation of East Caribbean States, two groups of former French colonies in Africa, and the a group of members of the European Union that have adopted the Euro. The East African dollar and the Central and West African francs are pegged to the Euro.

Theories of exchange rate determination

Volatility and speculation

References

  1. Effective Exchange Rates Explanatory note by the Bank of England
  2. Luci Ellis Measuring the Real Exchange Rate Research Discussion Paper 2001-04 Reserve Bank of Australia 2001
  3. United Nations, Commission of the European Communities, International Monetary Fund, Organisation for Economic Cooperation and Development and World Bank. System of National Accounts 1993 (SNA 1993). Series F, No. 2, Rev. 4 (United Nations publication Sales No. E.94.XVII.4)
  4. World Bank International Comparison Programme
  5. Paul Shreyer and Francette Koechler Purchasing Power Parities – measurement and uses OECD Statistics Brief March 2002
  6. Purchasing Power Parity Data OECD 2007