Understanding Currency Exchange Rates and International Trade
Currency Exchange Rates
To facilitate international trade, it’s necessary to understand relative prices for converting one currency into another. This involves:
- A market that produces currency exchange.
- A system that establishes exchange rates.
Transactions are made in the currency exchange market.
The Currency Market
Currencies are bought and sold in a specific market for several reasons:
- To gain financial profitability by buying and selling assets.
- To profit from variations in exchange rates.
The function of supply and demand of currencies determines the equilibrium price, which is called the exchange rate.
- A currency depreciates when it takes more of that currency to acquire a foreign unit.
- A currency appreciates when it takes less of that currency to acquire a foreign unit.
Demand, Supply, and Equilibrium in the Foreign Exchange Market
Demand for Foreign Currency (e.g., Dollars) or Supply of Euros
- Spanish importers of American goods.
- Spanish tourists spending their holidays in the U.S.
- Spanish investments in the U.S.
Supply of Foreign Currency (e.g., Dollars) or Demand for Euros
- Spanish exporters of American goods.
- American tourists spending their holidays in Spain.
- American investments in Spain.
Equilibrium Exchange Rates
The function of supply and demand of currencies forms the exchange rate. Any variations are caused by excess supply or demand.
Amendments to the Equilibrium Exchange Rate
Commercial Factors
- Exports: Goods produced domestically.
- Function of external demand: Domestic income and inflation differentials.
- Imports: Goods produced abroad.
- Function of domestic demand: Domestic income and inflation differentials.
Financial Factors
- Type of interest.
- Appreciation and depreciation of the currency.
Exchange Rate System
System of Fixed Exchange Rates
The government sets an exchange rate, which:
- Provides certainty to commercial and financial transactions.
- Prevents the exchange rate variation from being used as a trade weapon.
If the market exchange rate is greater than the equilibrium exchange rate:
- The government sells currency, then you can proceed to a devaluation.
- A contractionary policy hinders imports and encourages exports.
If the market rate is lower than the equilibrium exchange rate.
System of Flexible Exchange Rates
- If demand is greater than the supply, there is depreciation.
- If the offer is greater than demand, there is appreciation.
International Political Cooperation Agencies
- Organization of the United Nations (UN): Focuses on Third World development, environment, and disarmament.
- Food and Agriculture Organization of the United Nations (FAO).
Economic Partnerships
- International Monetary Fund (IMF): Focuses on financial stability and exchange rates.
- International Energy Agency (IEA).
- Development Assistance Committee (DAC).
Economic Development
Development is a process of historical knowledge of the economy, during which new technologies are applied. Development implies growth, but there can also be growth without development, which would lead to dualistic economic societies: economic growth in some sectors, while the rest remains underdeveloped.
Development is driven by:
- Technical progress.
- More integrated market.
- Capital accumulation.
- Free trade promoting exports.
- Human capital.
- Social and political conditions.
Growth follows a series of steps:
- Increase in agricultural productivity.
- Increase in the industrial sector.
- Dominance in the services sector.