Currency exchange rate
When transactions changed from the barter system to trading with currencies, the currencies issued in those times were coins made from gold or silver and stamped by the issuing authority. Governments in those times tried to fix the value of these coins by either increasing or decreasing the weight or purity of the coins.
When paper currencies were introduced, the governments in short of gold or silver coins devalued the value of the currency exchange rate by reducing its redemption value. Foreign currency exchange rate quotes When analyzing foreign exchange quotes two things need to be considered. They are: 1. The first currency listed will be the base currency. 2. The base value of that currency will always be 1. For example, when we see a quote like USD/CAD 1.68484, it means that one U.S. dollar is equal to 1.68484 Canadian dollars. Similarly, USD/JPY 128.88 gives the information that one U.S. dollar is equal to 128.88 Japanese yen.
In international trade because of the wide use of the U.S dollar, it is the base currency in a majority of the worldwide transactions. But there are some exceptions for the British pound (GBP), the Australian dollar (AUS) and the European currency unit, the Euro (EUR). When these three currencies are being used, the quotes will be represented as GBP/USD 1.6959, which implies that one British pound equals 1.6959 U.S. dollars. When a currency quote goes up against the base unit, for instance, the U.S dollar, it means that the dollar has appreciated in value and the other currency has significantly weakened. For example before the East Asian financial crisis, the exchange rate between the Indonesian currency and the U.S. dollar was about 2000 rupiah to one U.S. dollar. But during the financial crisis, the exchange quote was about USD/Rupiah 18000 i.e. one U.S. dollar was worth 18000 rupiah. It implied that the rupiah had depreciated to such lows against the dollar. In the above USD/Rupiah quote, the dollar has become stronger because it can buy more rupiah than before. In Britain, European Union countries and Australia, exchange rate quotation is made using the home currency of the respective countries as the unit or base currency, i.e., they follow the indirect quotation option. If the U.S. dollar is not the base currency, a rising quote means a weakening dollar and it takes more dollars to buy one pound, euro or Australian dollar.
Indirect quotation means 1 home currency unit = x foreign currency units. Most third world and developing economies use direct quotation option. Direct quotation means 1foreign currency unit = x home currency units. Factors affecting currency exchange rates The factors, which determine the value of a currency, are not just a single element but rather a combination of several other factors. No other market is so much influenced by the incidents and policies being implemented in different parts of the world like the foreign exchange market. The key factors that determine the currency exchange rate are the following: a) Economic conditions b) Political factors c) Market psychology a) Economic conditions Supply and demand forces normally determine the exchange rate of a currency. The economic policies formulated by governments and the central banks, the economic conditions normally revealed through economic reports and the other economic indicators like Gross National Product (GNP), consumer price index, unemployment statistics, stock market prices, industrial production etc are other aspects which determine the currency value. Economic policies like the fiscal policy (rules for budget preparation and spending) and the monetary policy (the methods adopted by the central bank of the government to influence the supply and value of the currency by controlling the interest rates) play a key role in determining the currency value. Currency exchange rate markets react negatively to widening annual budget deficits and positively to narrowing budget deficits. Two-way trade between two countries involves the exchange of goods and services and it involves the demand for currencies to conduct trade.
Trade surpluses reflect the competitiveness of an economy. Widening trade deficits always have a negative impact on the currency value, because it reveals that an economy is backward and underdeveloped. High inflation rate will quickly erode the value of a currency. When there is a general rise in prices and the purchasing power of the people remains low, the inflation is said to be high. When the purchasing power gets eroded, the demand and value of that particular currency declines in the international market. Low unemployment rate, consistent economic growth, a high gross domestic product (GDP), proper management of natural resources to produce good quality goods and services and high budget surpluses show that the economy is in good health. When the economy of a nation is healthy and robust, naturally there will be much demand for its currency and thus its exchange rate in the international market goes up. b) Political factors Political stability always has a positive impact on the currency markets. The national, regional and international political conditions will certainly influence the currency markets because in a globalized economy, no country can afford to stand alone and not be affected by the incidents in another country because almost all nations are interdependent on one another for goods and services.
Countries facing the scourge of civil war, political instability, ethic unrest and also incompetent under-performing governments have currencies that do not command any value or demand in the international currency market. c) Market psychology Market psychology is a difficult to define aspect because there are no balance sheets or any income statements to refer to. Any sudden event nationally or internationally will lead to investors trying to seek safe havens in countries with strong currencies substantially weakening the currencies of economies deemed to be unsafe because of the sudden flight of outflow of capital. Even rumors about an anticipated event are enough to cause a rippling effect in the financial markets and the currency exchange rate.
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