Exchange rate

The rate or exchange rate between two currencies is the rate or ratio of proportion that exists between the value of one and the other. This rate is an indicator which expresses how many units of one currency it takes to get one unit of the other.
For example, if the exchange rate between the euro and the US dollar EUR/USD were 1.12, this means that the euro is equal to 1.12 dollars. Similarly, if the rate is calculated in reverse (USD/EUR), this results in a rate of 0.89, which means that the dollar is equal to 0.89 euros.

The birth of an exchange rate system comes from the existence of international trade between different countries that have different currencies. If, for example, a Mexican company sells products to a Spanish company, they want to charge in pesos, so the Spanish company must buy Mexican pesos and use them to pay the Mexican manufacturer. Currency for international payments is purchased predominantly from banks and various forms of exchange houses. The exchange rate is determined by the market value of the different currencies in the international market.

Determination of the exchange rate per hour

The exchange rate is determined through the foreign exchange market. The exchange rate as the price of a currency is established, as in any other market, by the meeting of supply and demand for currencies. If a hypothetical situation is analysed, for example, in which there are only two currencies, the euro and the dollar. The demand for dollars (supply of euros) arises when consumers in different European countries need dollars to buy goods from the United States. In the same way, dollars are needed if a European company wants to buy a building in New York, when a German citizen travels as a tourist to San Francisco or if a Swedish company buys shares of a North American entity, but there may still be an additional reason to sue. dollars, which is pure speculation, that is, the thought that the dollar is going to rise in value with respect to the euro will cause the demand for dollars to rise.

If we analyze the opposite, the supply of dollars (demand for euros), this is done by all those companies and citizens who need euros for their needs (basically the same ones that we have analyzed before, purchase of goods and services, investments and speculation.)

The balance in a competitive market between supply and demand will set the price of the dollar against the euro or, what is the same, the price of the euro against the dollar. In the foreign exchange markets, depreciation is known as the decrease in the price of one currency with respect to another.

Exchange rate system

It is a set of rules that describe the behavior of the central bank in the foreign exchange market. Two opposing exchange rate systems are identified:

• Fixed exchange rate: is determined rigidly by the Central Bank.
• Flexible exchange rate: is determined in a free market, by the game of supply and demand for currency. In economies with flexible exchange rate, balance-of-payment imbalances are automatically corrected by depreciation or appreciation of the type of changes.

Real exchange rate

Two types of changes can be distinguished: real and nominal. The real is defined as the ratio at which a person can exchange the goods and services of one country for those of another. The nominal is the correlation at which a person can exchange the currency of one country for those of another, that is, the number of units I need of currency X to get one unit of currency Y. The latter is the most frequently used.

This distinction is necessary to appreciate the true purchasing power of a currency abroad and avoid confusion.

The Real Exchange Rate is defined as the quotient between the external price level and the internal price level, measured in the same currency. This measures how competitive an economy is in international trade with respect to others.

Formally, the real exchange rate, R, is defined as:

R=(e× × PfP){displaystyle R=left({frac {etimes {P_{f}}}{P}}}right)}

Where:

e{displaystyle e} = nominal exchange rate (market exchange rate)

Pf{displaystyle {P_{f}}} = External price level

P{displaystyle P}= Domestic price level

Deadlines

The settlement time of transactions made with currencies can be:

• Type of spot change: the type of spot change refers to the type of current exchange, that is, transactions made on account.
• Future exchange rate: the future exchange rate indicates the currency price in current operations, but the liquidation date is in the future, for example, within 180 days.

Influence on fiscal deficit

Fixed exchange rate

Analysis of the budget deficit is complicated when the exchange rate is fixed. Under a fixed exchange rate system, the central bank does not actually determine the money supply in the same way as in a closed economy or when operating under a flexible exchange rate system. Remember that under a fixed exchange rate the variation in the money supply is endogenous, and that it responds to the purchases and sales of foreign currency made by the central bank to comply with its commitment to keep the exchange rate fixed.

Fundamental identities in an open economy

In an open economy imports are positively related to income and output. When the gross domestic product is increasing rapidly, imports tend to increase faster. On the other hand, the choice between foreign and national goods responds to the relative prices of the two. Therefore the volume and value of imports depend on the relative prices of domestic and foreign goods. The exchange rate affects foreign trade, in such a way that when the exchange rate of a country falls, the prices of imported goods rise, while exports become cheaper for foreigners. As a consequence, the country is more competitive in world markets and net exports increase. Changes in exchange rates can profoundly affect output, employment and inflation. All these effects make the exchange rate increasingly important for all countries.

Exports are the twin sister of imports: our exports are the imports of the rest of the world. They depend, therefore, mainly on the income and products of our trading partners as well as the relative prices of our exports and the goods with which they compete. When foreign production increases or when the exchange rate rises (ie the domestic currency depreciates), the volume and value of our exports tend to grow.

Once we factor in exports and imports, we must also recognize that a country's spending may be different from its output. Domestic spending (sometimes called domestic demand) is equal to consumption plus domestic investment plus government purchases. It differs from the total national product (or GDP) for two reasons. First, a part of domestic spending goes on goods produced abroad and these are imports (M), such as oil and Japanese cars. A part of the country's production is sold to other countries and is exports (X). The difference between domestic production and domestic spending is simply (X-M) called net exports.

To calculate a country's total demand for goods and services, we have to include not only domestic demand but also foreign demand. That is, we have to know the total spending of residents in the country, as well as the net purchases of foreigners. This total must include domestic spending (C + I + G) plus sales to foreigners (X) minus domestic purchases from foreigners (M). Spending on the national product or GDP is equal to consumption plus domestic investment plus government purchases plus net exports.

Total aggregate demand = GDP = C + I + G + (X - M)

Foreign trade produces an effect on GDP similar to investment or government purchases. When net exports increase, the aggregate demand for domestic production increases. Therefore, net exports have a multiplier effect on production. But the spending multiplier will be lower in an open economy than in a closed one because of the leakage of spending to imports. The multiplier is:

Open economy multiplier = 1/ (marginal propensity to save + marginal propensity to import)

It is clear that, all else being equal, the multiplier for an open economy is smaller than that for a closed economy, where PMm = 0.

Exchange rates and the balance of payments

The connection between exchange rates and balance of payments adjustments, in the simplest case that exchange rates are determined by supply and demand, in which a country starts out in equilibrium and then suffers a disturbance in its balance of payments. For example, a rise in interest rates to curb inflation and thus increase foreign demand for assets in this country. There would be an excess demand for this currency at the old exchange rate. At this rate, the country would tend to run both a trade and financial surplus, since the amount of currency entering the country would increase.

This is where the exchange rate plays the role of balancer. When the demand for the currency increases, the situation causes an appreciation of this and a depreciation of the others. The exchange rate variation continues until the balance of payments accounts rebalance. The current account balance is easier to understand. In this case, the appreciation of the currency makes the country's merchandise more expensive and causes a decrease in exports and an increase in imports, which tends to reduce the country's current account surplus. Therefore, in a system of flexible exchange rates, the balance of payments is balanced without intervention from the central bank.

On the contrary, in a system of fixed exchange rates, the balance of payments is balanced with the intervention of the central bank through the purchase or sale of currencies included in the variation of reserves. However, this situation cannot be maintained indefinitely. If the deficit is permanent, the central bank will not allow foreign exchange reserves to run out, which is why it can carry out a devaluation. This has the disadvantage that it will mean a rise in the prices of imported goods that can be transmitted to national goods. In this way, inflation in the country that has devalued makes the gain in nominal competitiveness, caused by the cheapening of its currency, disappear.