Exchange Rate

This article focuses on exchange rate. It provides an overview of the ways in which governments and policymakers implement exchange rate policy to control and stabilize national economies. The main types of exchange rate regimes, including floating exchange rate regimes, managed exchange rate regimes, and pegged exchange rate regimes, will be described. The issues associated with exchange rate management will be discussed.

Keywords Business Cycle; Depression; Dollarism; Economic Contraction; Economic Expansion; Economic Exposure; Exchange Rate; Exchange Rate Management; Exchange Rate Policy; Exchange Rate Regimes; Fiscal Policy; Floating Exchange Rate Regimes; Forex Markets; Growth Cycles; Managed Exchange Rate Regimes; Monetary Policy; Monetary Union; Pegged Exchange Rate Regimes

International Business > Exchange Rate

Overview

An exchange rate is a comparison between a national currency and a foreign currency. Exchange rates are flexible expressions that may serve as a multiplier, ratio, or price. There are multiple types of exchange rates: Nominal, real, bilateral, and multilateral.

• Nominal exchange rates are reported daily in newspapers around the world and are based on financial markets called forex markets. Forex markets, also referred to as foreign exchange markets, are markets in which buyers and sellers conduct foreign exchange transactions. Nominal exchange rates may be fixed for a period of time by a central bank.
• Real exchange rates are nominal exchange rates that include adjustments based on inflation measures.
• Bilateral exchange rates are based on the comparison of two countries’ currencies.
• Multilateral exchange rates are based on the comparison of multiple currencies. Multilateral currencies evaluate the dynamics of a country's currency toward the rest of the world and produce an effective country-specific exchange rate.

Some countries may choose to employ a system of multiple exchange rates. Different exchange rates may be used in commercial transactions, public transactions, consumer transactions, and investment transactions. Countries that do not have an explicit policy of multiple exchange rates may choose to unofficially have multiple exchange rates in the form of the official exchange rates and black market exchange rate. Exchange rate classifications are based, in part, on the number of currencies involved in comparisons.

Exchange rates and the global or macroeconomy are closely related. A country's exchange rate influences exports, imports, job rates, working conditions, external purchasing power of residents abroad, and trade balances. For example, a rising exchange rate depresses exports, boosts imports, and depresses the trade balance (Piana, 2001). International capital markets respond to exchange rate fluctuations and exchange rate volatility. Exchange rate variability and volatility depress trade and the economy in general. In an effort to limit exchange rate variability, international governance organizations, such as Group of Seven (G-7) industrialized countries and the European Union (EU), have explored the possibility of establishing informal target ranges for exchange rates. There is no international consensus on how currency relations among major regions should be approached or governed (Obstfeld, 1995); in the wake of the global financial crisis of 2008, in 2010, the G20 and the International Monetary Fund agreed to devise plans for global currency regulations, but, as of 2013, no such regulations have been put in place (Council on Foreign Relations, 2013). Variables that affect nominal exchange rates include exports, imports, and trade balances; the demand for currency; past and expected values of the financial market; and the interest rate on treasury bonds. Governments must carefully manage interest rates due, in part, to the effect that interest rates have on exchange rates. The following section provides an overview of the ways in which governments and policymakers implement exchange rate policy to control and stabilize national economies. This section serves as the foundation for later discussion of exchange rate regimes and the issues associated with exchange rate management.

Exchange Rate Policy

Governments employ exchange rate policies to control the economy. For example, in times of exchange rate devaluation or depreciation, a central bank may issue a fixed exchange rate as an anchor for the economy (Piana, 2001). Exchange rate policy, along with trade policy, monetary policy, and fiscal policy, is used to control economic transitions and to achieve economic equilibrium. Governments and policymakers use two main approaches to exchange rate policy: The real targets and the nominal anchor approach.

• The real targets approach views the nominal exchange rate as a policy tool.
• The nominal anchor approach holds that a country's exchange rate should move toward fixity to introduce credibility, maintain financial discipline, and reduce inflation.

Currency convertibility is a central part of exchange rate policy. Currency convertibility is considered to be a central part of economic transitions. Currency convertibility imports a new price structure, creates competition, eliminates administrative allocation of foreign exchange, and serves as a symbol of openness and economic freedom. Economies in transition often undergo exchange rate reform. Exchange rate reform refers to a process of improving or removing administrative restrictions over exchange rate decisions as part of the larger goal of transition to a market economy.

The U.S. & China

The United States and China offer examples of exchange rate policy and exchange rate reform. Neither the United States nor China had effective explicit exchange rate policy in place until late in the twentieth century. Throughout much of the twentieth century, the U.S. economy continued its trade policy without explicit policy on exchange rates. The Chinese economy was undergoing a transition throughout the twentieth century and exchange rate policy, begun in 1980, facilitated the transition and strengthened the market driven economy. China's exchange rate reform in the 1980s and 1990s directed the transition of the Chinese economy from a planned economy to a dynamic, market-driven economy. China adopted the real targets approach to exchange rate reform. Exchange reform in China occurred in four main stages: Reform Stage I (1981-1985); Reform Stage II (1986-1991); Reform Stage III (1991-1993); and Reform Stage IV (beginning in 1994). China unified multiple exchange rates in 1994 with a managed and market-determined floating rate, while abolishing planning controls over the use of foreign exchange for imports (Zhang, 2000).

In contrast to China, the United States had no coherent policy on exchange rates until the late 1990s. The U.S. Treasury issued policy statement on exchange rate regimes in 1999. The U.S. Treasury announced that either floating or fixed exchange rates were acceptable in the U.S. economy and marketplace but pegged exchange rates were not (Hanke, 2002). In the United States, the economy is controlled primarily by fiscal policy. Fiscal policy refers to expenditures by federal, state, and local governments and to the taxes levied to finance these expenditures. Fiscal policy supports and funds the federal budget, aids the federal government's social policies, and promotes overall economic growth and stability. The history of the U.S. economy is full of economic expansion and economic contraction. Following the American Revolution, the individual economies of the states were faltering, paper money had little value, and there was conflict between borrowers and lenders. The original thirteen states came together to draft the U.S. Constitution, in part, to stabilize and strengthen the U.S. economy.

From the Civil War through the beginning of the Industrial Revolution, the U.S. economy was characterized by cycles of growing and contracting. In the 1930s, following the Great Depression, the United States government began a program and approach of mixed fiscal and monetary policies in an effort to produce sustained economic growth and stable prices (for goods, services, and natural resources). The government, with a strong record in the latter half of the 20th century for controlling cycles of expansion and contraction, remains challenged by inflation and related problem of unemployment. Today, the U.S. dollar, despite its great volatility, is the predominant currency worldwide. For example, nearly ninety percent of all internationally traded commodities are valued, priced, and invoiced in U.S. dollars. Despite the prominence of the U.S. dollar, the United States government is reconsidering the role of exchange rate policy in economic operations. Economic globalization requires increased sensitivity to issues of exchange rate, interest rate, and trade policy (Hanke, 2002).

Application

Exchange Rate Regimes

Exchange rate regimes, also called currency institutional regimes, refer to specific institutional structures designed to produce specific exchange rate outcomes. The main exchange rate regimes, including floating, fixed, and pegged, are characterized by different levels of control and produce different results. Exchange rate regimes are closely connected to international economic policy. The field of international economic policy debates the merits of different exchange rate regimes and international financial architecture. The field of international economic policy is working to identify viable international exchange rate regimes for a wide range of markets. The increase in global capital flows between the 1970s and 1990s increased international trade, portfolio diversification, and risk-sharing. Countries invested in international trade are increasingly faced with the decision of whether or not to give up their nation's monetary-policy autonomy. Instability in foreign markets increasingly transmits instability abroad through a process of economic contagion.

Main Types of Exchange Rate Regimes

The main exchange rate regimes, including floating, managed, and pegged, are described below (Tavlas, 2003):

• Floating exchange rate regimes have no commitment to a specific exchange-rate target. In floating exchange rate regimes, the exchange rate is determined by market supply and demand rather than macroeconomic policy. The U.S. dollar and the Euro tend to have floating exchange rates.
• Managed exchange rate regimes have no constant exchange rate target. Instead, policymakers tweak interest rates to raise or lower the exchange rate as needed. Managed exchange rate regime refers to scenarios in which the central bank intervenes in the currency market to achieve a variable currency target. Policymakers make these adjustments on a daily, weekly, or monthly basis to counteract misalignments in the economy. Misalignments refer to a sustained departure of the exchange rate from what policymakers perceive to be its equilibrium value.
• Pegged exchange rate regimes include a set exchange rate targets. Policymakers use monetary policy to maintain the established exchange rate target. Examples of pegged exchange rate regimes include soft peg, adjustable peg, and crawling peg. Adjustable peg regimes tend to include infrequent large adjustments in response to perceived differences between the target exchange rate and the equilibrium rate. Crawling peg regimes operate with a target exchange rate zone rather than a single exchange rate target and tend to include frequent small adjustments to the exchange rate.

These three competing exchange rate regimes have different strengths and weaknesses. Emerging market economies and long established market economies will choose their exchange rate regime based on the different economic needs of citizens and government and the established economic infrastructure. Both freely floating exchange rate regimes and managed floating exchange rate regimes experience depreciations. Depreciations refer to a loss in currency value. Stable fixed exchange rate regimes experience devaluations and revaluations. Devaluation refers to a loss of value forced by market or a purposeful policy action. Revaluation refers to an increase of international value. All exchange rate regimes may experience currency crisis. Currency crisis refers to a rupture of fixed exchange rates with an unwilling devaluation or even the end of that regime in favor of a floating exchange rate (Piana, 2001).

Other Means of Controlling Exchange Rates

In addition to exchange rate regimes, exchange rates can be controlled and directed through other means such as currency boards, dollarism, and monetary unions (Tavlas, 2003).

• Currency boards issue money that is convertible on demand at a fixed rate of exchange. Currency boards guarantee their commitment through the use of a foreign anchor currency and establishing the exchange rate as a public law. Currency boards cannot extend credit or determine the amount of money in circulation.
• Dollarism, also referred to as Euroisation, is a process in which a country formally adopts a foreign currency as it legal tender. Under this system, the country's monetary base is exchanged in total for the adopted foreign currency and all contracts previously established in the local currency must be reconfigured in the adopted foreign currency.
• Monetary union, also called monetary unification, is a process in which a group of economies adopt a single currency and a common central bank. The community entity takes over control of exchange rate policy and the responsibility to oversee balance of payments of member economies with non-member economies and countries. Individual member economies give up their individual rights to establish monetary policy for their economy.

International monetary organizations debate the strengths and weaknesses of extreme exchange rate control mechanisms such as floating exchange rate regimes and monetary unification. Emerging market economies may thrive with floating exchange rates but require inflation targeting. This system is called managed floating. Managed floating exchange rate is free to act as a market gauge for assessing policies and as a mode of conflict resolution. Countries analyze exchange rate regime choices based on the balance between internal price stability and external competitiveness (Klyuev, 2002).

Issues

Exchange Rate Management

Multinational corporations face exchange rate exposure or risk. In particular, multinational corporations face foreign currency risk. The exchange rate exposure of firms has potentially positive or negative impacts on the profitability and value of the firm (Jorion, 1990). Exchange rate variability effects firm operations, revenue, and valuation. For example, exchange rate variability creates cash flow risk for firms with foreign assets and liabilities. Exchange rate exposure refers to the sensitivity of its economic value, or stock price, to exchange rate changes. The major causes of increased foreign exchange risk include the following: “The adoption of a floating exchange rate regime; the rapid globalization of national economies; and the attempts by multinationals to seek investment opportunities and markets beyond their immediate borders” (Zubeiru, 2007, p.380). Due to the difficulty in predicting exchange rate movements, corporate managers and analysts have developed management and analytical strategies, such as the Jorion two-factor model, to neutralize exchange rate risks (Zubeiru, 2007). Exchange rate managers and analysts use the Jorion two-factor model to estimate the exchange rate exposure of a situation, group, or scenario (Jorion, 1990).

Exposure on an International Level

Risk managers are responsible for exposure management in general. Exposures refer to categories of risks faced by a firm. International financial managers protect the firms from exchange rate exposure, transaction exposure, economic exposure, and translation exposure. Risk managers work to reduce exposures faced by their firms.

• Exchange rate exposure reflects the extent to which currency exchange and exchange rate fluctuations will affect firm activities and profits.
• Transaction exposure refers to the degree to which future cash transactions are affected by exchange rate fluctuations. Risk managers control transaction exposure by analyzing extent and range of exposure by country for all activities of the organization. Risk managers are responsible for developing inflows and outflows of cash in multiple currencies. In scenarios in which the transaction exposure is high, risk managers may choose to use a hedging technique to reduce the risk.
• Economic exposure refers to the degree to which a firm's present value of current cash flows is affected by exchange rate fluctuations. International financial managers control economic exposure through the application of techniques such as debt restructuring, modified sales activity, adjusted orders with suppliers, and adjusted production volumes by country. International financial managers adjust their orders with suppliers and their production volume in different countries in an effort to reduce their economic risks.
• Translation exposure, also known as accounting exposure, refers to the risk that a firm's equities, assets, liabilities, and income will change in response to exchange rate fluctuations. International financial managers control translation exposure through the use of consolidation techniques and carefully-chosen cost accounting evaluation procedures (Delk, 2000).

A firm's total exposure refers to economic effects resulting from exchange rate exposure, transaction exposure, economic exposure, and translation exposure.

Controlling Exchange Rate Exposure

Risk managers control exchange rate exposure, in part, by monitoring and managing the business cycle. Exchange rates are closely related to the business cycle. The business cycle, which includes a peak, recession, trough, and expansion, is a cycle of economic contraction and expansion. There are two types of business cycles: Classical cycles and growth cycles.

• Classical cycles refer to hills and valleys in a series that represent the overall economic activity level.
• Growth cycles refer to repeating fluctuations in the growth rate of overall activity in relation to the long-run growth rate trend.

The measurement and analysis of business cycles is crucial for the economic health of the public and private sectors. Economic indicator analysis is one of the main tools used in measuring and analyzing business cycles. Economic indicator analysis involves using leading and coincident indexes of economic activity as strong forecasting factors or tools (Boehm, 1999).

Managing the Business Cycle

Managers often oversee exchange rate exposures and business cycle exposure simultaneously. Business cycles have a profound effect on business stakeholders owners, employees, investors, and society at large. The expansions and contractions the economic business cycles create an environment of economic risks and uncertainties in the business sector. Firms use management strategies, tactics and forecasting tools to survive through the economically challenging times during a business cycle. Business cycles must be managed by businesses to avoid economic collapse during periods of economic contraction. Executives with high levels of business cycle literacy may be referred to as master cyclist executives. There are three broad and general objectives that businesses use to manage the business cycle: Evaluate the capabilities and resources that a firm may deploy to hedge or leverage business cycle risk; articulate strategies and tactics that companies may use to better manage business cycle volatility; and develop prescriptive measures in areas ranging from marketing, pricing, and human resources management in order to improve business cycle management. Risk managers perform two main tasks in business cycle management.

• First, risk managers hedge general business cycle risk by using tools such as business unit and geographical diversification.
• Second, risk managers hedge the specific risks potentially caused by movements in commodity and oil prices, interest rates, and exchange rates by using financial derivatives such as call options and futures (Navarro, 2006).

Savvy risk managers, who are aware of the relationship between exchange rates and business cycles, can often predict economic recession and prepare and protect their business accordingly.

Conclusion

In the final analysis, an exchange rate is a comparison between a national currency and a foreign currency. Exchange rates are flexible expressions that may serve as a multiplier, ratio, or price. There are multiple types of exchange rates: Nominal, real, bilateral, multilateral, and multiple. Countries choose their exchange rate regimes based on the needs of their economy and the economic architecture and institutions available to direct and guide the exchange rate. Exchange rate fluctuations affect the strength of national economies and local businesses alike. Exchange rate management, as part of a larger system of exposure management and business cycle management, is vital for the success of most businesses.

Terms & Concepts

Business Cycle: A fluctuation in the overall economic activity of nations that are organized around the operation of business enterprises.

Depression: A sustained economic recession.

Dollarism: A process in which a country formally adopts a foreign currency as it legal tender.

Economic Contraction: The downward phase of the business cycle.

Economic Expansion: The upward phase of the business cycle.

Economic Exposure: The vulnerability of a firm’s earnings to exchange rate fluctuations.

Exchange Rate: A comparison between a national currency and a foreign currency.

Exchange Rate Regimes: Specific institutional structures designed to produce specific exchange rate outcomes.

Fiscal Policy: The expenditures by federal, state, and local governments and the taxes levied to finance these expenditures.

Forex Markets: Markets in which buyers and sellers conduct foreign exchange transactions.

Growth Cycles: Repeated fluctuations in the growth rate of collective activity in relation to the long-run growth rate trend.

Monetary Policy: A tool used by the federal government to control the supply and availability of money in the economy.

Monetary Union: A process in which a group of economies adopt a single currency and a common central bank.

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Suggested Reading

Bonitsis, T. (2013). Is the real u.s. dollar exchange rate neutral? Journal of Business & Economic Studies, 19, 71–84. Retrieved November 21, 2013 from EBSCO online database, Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87634903&site=ehost-live

ÉGert, B., Halpern, L., & MacDonald, R. (2006). Equilibrium exchange rates in transition economies: Taking stock of the Issues. Journal of Economic Surveys, 20, 257-324. Retrieved October 6, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=20251772&site=ehost-live

Jeanne, O., & Rose, A. (2002). Noise trading and exchange rate regimes. Quarterly Journal of Economics, 117, 537-569. Retrieved October 6, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=6576200&site=ehost-live

Narayan, P., & Smyth, R. (2006). The dynamic relationship between real exchange rates, real interest rates and foreign exchange reserves: Empirical evidence from China. Applied Financial Economics, 16, 639-651. Retrieved October 6, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=21001349&site=ehost-live