Exchange Rate Term Paper

Excerpt from Term Paper :

Theoretically speaking, there is only one factor affecting the exchange rate of a country adopting a floating exchange rate regime: the supply and demand of the respective currency on the international market. In this sense, if demand exceeds supply, then the value of the currency will go up and the respective currency will appreciate. On the other hand, if supply exceeds demand, the currency will depreciate and the price of the currency will decrease.

Starting from this statement, however, we can discuss several different factors that make the demand and supply vary, affecting thus the exchange. First of all, we have the level of the interest rate in a country. If the interest rates are higher, then foreign investors will choose to enter the national capital markets, purchase local currency and invest in local bonds or T-bills, which bring high returns, due to high interest rates. This mechanism will lead to an increased demand and a higher exchange rate, with a stronger national currency.

On the other hand, the inflation rate plays a serious role as well. In this sense, if the inflation rate is higher than the interest rate, the returns will tend to be negative and demand for the local currency will decrease. This will drive the exchange rate downwards.

The third element affecting the exchange rate we should mention is the trade balance. In general, favorable terms of trade increase demand for a particular currency and the exchange rate will most likely rise

In my opinion, the economy itself is the most important factor that affects the exchange rate of a national currency. Indeed, if the economy has significant growth rates, if there is a general confidence from the foreign investors that the trend will continue into the future as well and if there is macroeconomic stability, then foreign investors will most likely look for the respective national currency. We should look, for example, at a report published in March 2004, on the failure of U.S. economy to create new private jobs

In the respective announcement, the public found out that the U.S. economy had produced only 21,000 new jobs and none in the private sector, from the 150,000 that had been predicted previously. The signal this send the investors was quite clear: the U.S. economy is not performing as well as we may have thought, it is not producing new workplaces (which would be a sign of rising business, as new employees would be needed). The subsequent devaluation of the U.S. dollar was a natural psychological reaction from the investors.

As such, as a last factor besides those already enumerated (interest rates, inflation rates, foreign trade, economy growth rates), we should mention the psychological factor affecting supply and demand in general. On the foreign exchange market, this is particularly sensitive.

(b) In general, we may assume that the advantages of a floating exchange rate are also the disadvantages of a fixed exchange rate and the other way round as well, because the two systems are the exact opposite of each other.

The first and most important advantage of a floating exchange rate refers to the availability of adjustments that the floating exchange rates provide. I am referring, first of all, to economies that have large deficits and where the respective pressure is "put downward on the exchange rate"

. Basically speaking, a floating exchange rate helps take over some of the pressure that is laid on the economy in the case of a large deficit. This is the case of the United States these days

. The persistent problem of the budget deficit, the exorbitant levels of public and external debt have led to a devaluation in the dollar exchange rate, because the country has spent more than it has received and has imported more than it has exported.

In this sense, the reverse way is also available: the government itself takes measures for lowering the exchange rate (this is generally done by selling national currency on the international markets) in order to boost up exports and lower public deficits (if the national currency depreciates, the local exporters, who are paid in the currency of the country they are exporting to, will benefit, before they will produce cheaper, using a devaluated currency, and will sell to higher profits on a stronger currency).

The second advantage of a floating exchange rate that is worth mentioning refers to the flexibility in determining interest rates

. The level of the exchange rate, the level of the interest rates and the state of an economy are in a close connection. The government can use either of the first two mechanisms in order to encourage the third in times of recession. As such, a low exchange rate will drive interest rates down as well, with a signal for the investors to spend the money in the economy instead of having it in banks or other financial instruments with interest rates.

If we refer to fixed exchange rates, the main advantage one can think of and the most important is the fact that a fixed exchange rate is safe or safer from speculative activity. If we look at some of the crisis in the 90s, almost all of them were caused by speculative activities. The Asian Crisis, the Russian Crisis, but also the strong depreciations of the Italian Sterling and British Pound had the same underlying elements at base. In the Asian Crisis, for example, George Soros speculated large sums of money (estimated around 60 billion U.S. dollars) on several Asian currencies (Malaysian, Thai Baht), gained a few billion for himself and destabilized for several years to come the respective national currencies. If the countries in South-Eastern Asia would have had a fixed currency exchange rate, it is more than probable that they would have never been in any danger.

Further more, a fixed exchange rate mechanisms imposes "tight controls on capital flows to and from the economy" and a general financial discipline can be considered one of the characteristics of such exchange rate mechanisms, with low fluctuations in financial data and low inflation rates (Bulgaria, for example, has successfully reduced its inflation rate since it adopted a fixed exchange rate mechanism from 1000% to 2-3%).

However, in the late 90s, Argentina became one of the most tragic examples of what can happen to a country that practices a fixed exchange rate mechanism. Pegged to the U.S. dollar, the national currency could no longer truly reflect what was going on in the economy and the economic growth rates had left the local currency highly over appreciated. The country still feels the consequences of what has happened then and the economy has just begun to recover.

(c) There are several comparisons we can make in order to describe and explain the depreciation of the U.S. dollar against the Euro since 2002. In December 2002, the Euro-USD exchange rate was 1.0085 to 1 (you paid 1.0085 dollars for 1 Euro). In December 2004, this has reached 1.3246 to 1. This means that the dollar has lost around 30% from its value against the Euro.

There are several reasons for this decreasing trend we should present. The most important one is, in my opinion, the immense public and current account deficit that have turned some investors away from the American currency, afraid that the U.S. economy would not be able to sustain such huge debt. Additionally, the American authorities find in the present a weak dollar as a help in lowering this deficit. Indeed, as I have described previously, a weak currency encourages exports. A weak dollar against the euro will boost up exports to Europe.

On the other hand, there have been several negative signals towards the U.S. economy during this period. The global recession and the attacks on September 11 caused huge losses for companies in the insurance, aviation, even tourism industries. These were some of the best producers in the economy who now suddenly saw their business taking a downturn they could not sustain and could not afford.

Lately, there have been rumors, especially from Russia and China, that they intend to change their dollar reserves into more stable euros. Affected by the recent moves on the financial markets, the Russian authorities have announced that they intend to change part of their reserves in Euros. This would mean a huge, destabilizing supply of American currency on the market. According to the theory previously presented, an increasing supply will naturally lead to the further depreciation of the U.S. dollar against the Euro.

Nevertheless, in November and December 2004, there have been almost no prospects for the persistent depreciation of the U.S. dollar against the Euro up to a value that has almost reached 1.35. Indeed, the U.S. economic growth rate in 2005 is expected to be twice the rate in the European Union, according to the OECD predictions. This would indicate that the U.S. economy has surpassed the period of recession and is now performing well. This trend should encourage the investors to…

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