Campaign Agent Johnny Wordsworth Economics terms are thrown about by those in-the-know all too regularly. Frankly, its baffling for those of us without expert knowledge in the subject, and “put simply” explanations are infrequent, to say the least. #LetsTalkPolitics and challenge this.
An exchange rate can simply be defined as the price of a nation’s currency in terms of another currency. Essentially, the price of the pound Sterling in regard to the US Dollar. An exchange rate (ER) has two parts, the foreign currency and the domestic currency, which can both be compared indirectly or directly to one another. Put simply, an exchange rate is the purchasing power of one currency compared to another. The Bank for International Settlements recorded global trading in foreign exchange markets averaging a staggering $5.1 trillion per day in April 2016.
An ER rate can be measured in a few various ways; firstly via the ‘Spot exchange rate’, which is essentially the rate for a currency at today’s market prices. Secondly, via the Bilateral Exchange Rate’ - the rate at which one currency can be traded against another, such as the Sterling against the Euro. Thirdly, via a ‘Forward exchange rate’ which is what the expected exchange rate will be at a certain point in the future (this is usually for companies to reduce risk).
The ER can have large macroeconomic effects on a country, both beneficial and negative. In addition, it is often used as a strategy by governments to affect aggregate demand (total demand within an economy).
There are three types of ER:
1. Floating: A floating exchange rate occurs when governments allow the exchange rate to be determined by market forces and there is no attempt to influence the exchange rate. Essentially the rate is set by FOREX (Foreign exchange) demand and supply.
2. Fixed: Fixed rates are currency values which are tied to certain things, examples could be commodities like tea, oil and Iron or even currencies like the Dollar.
3. Managed: Managed exchange rates exist when a currency partly floats and is partly fixed, this type of ER is mainly adopted.
Fixed exchange rates: Advantages
- Increased certainty for businesses
- Control of inflation, restriction of demand if needs be
- Would lead to orderly international currencies resulting in price stability of the global markets
Fixed exchange rates: disadvantages
- Negative speculation can occur, if a country is persistently in deficit then international opinion will stay the same as its fixed
- There will be a need to change the exchange rate as countries grow at different rates
Floating exchange rates: advantages
- Continuous and automatic adjustment as the FOREX market changes to reflect a countries currency purchasing power against another
- Reduced speculative pressure, expectations can’t be made as the rate is floating
Floating exchange rates: disadvantages
- Detrimental effects on inflation – when the currency depreciates imports increase in price, hence business costs rise and therefore average prices rise, leading to increased costs to consumers
- Higher volatility - Floating exchange rates are highly volatile. Prediction can’t occur in the short-run