Exchange rate represents the price of one currency when we exchange to another currency. For example, the current exchange rate of Rp/USD is 14,000. USD is the base currency or base currency (foreign currency), and Rp is the price currency (local currency). We can say that 14,000 rupiahs can buy 1 US dollar. Or, if we need 1 US dollar to get Rp14,000.
The rate of currency exchange depend on the exchange rate system in each country. Two common systems are fixed and flexible exchange rates, each with several variations. Fixed exchange rates fix the price of your currency at a certain level with other currencies or gold, and it will not fluctuate. Meanwhile, flexible exchange rates allow currency prices to rise and fall, depending on supply and demand in the foreign exchange market.
In geneneral, a stable exchange rate is more desirable. Conversely, large and unexpected changes can create uncertainty for businesses.
Differences in exchange rate and currencies
The exchange rate refers to the purchasing power of one country’s currency against another country’s currency. In other words, we calculate it by dividing the amount of currency you have by the amount of currency you want to exchange. For example, suppose you have banknotes with a nominal value of Rp50,000 and want to get US dollars. You exchange it at a money changer and get USD3.57. That means the exchange rate of your currency against the dollar is 14,000 per US dollar (50,000/3.57).
Meanwhile, currency refers to the value of the currency itself. That is the nominal value that you see on banknotes or coins that you hold. In the case above, your currency is Rp50,000.
Exchange rate system
In general, the two types of exchange rate regimes are fixed and flexible. Both have several modifications, depending on the economic policies in each country.
A fixed exchange rate is when a country ties the value of its currency with other currencies or certain commodities such as gold. The US dollar is usually a benchmark in fixed exchange rates because many countries use it in international trade.
Meanwhile, the flexible regime hands over the price of the domestic currency to the market mechanism. Demand and supply in the foreign exchange market determine the price. The government does not intervene.
Fixed exchange rates bring stability and predictability because currency prices are set at a certain level. However, it also requires the government to intervene through buying and selling on the forex market actively. Intervention requires a lot of currency reserves so as to make it credible. Otherwise, the exchange rate is vulnerable to speculative attacks.
Another weakness of fixed exchange rates is that economic policy is dependent. Policymakers must adjust their policies with monetary policy abroad. For example, when international interest rates rise, the domestic central bank must also raise interest rates, ensuring that the spreads are fixed. If the domestic central bank does not raise interest rates, capital will flow out to seek higher returns abroad. That will lead to depreciation.
Meanwhile, flexible exchange rates do not require intervention. And, therefore, it also does not require large currency reserves. Free exchange rate movements also support to ensure a balanced trade balance.
However, large fluctuations bring uncertainty in economic decision making. Speculative attacks can also exacerbate its fluctuations and have a significant impact on the economy.
Exchange rate fluctuations
In a flexible regimes, prices of the domestic currency can go up and down, depending on the balance in the foreign exchange market. When the price of the domestic currency falls relative to foreign currencies, that means, the domestic currency is depreciating. Conversely, appreciation occurs when the domestic currency strengthens relative to foreign currencies.
When it depreciates, the domestic currency, with the same nominal, buys fewer foreign currencies. For example, the rupiah exchange rate changes from Rp15,000/USD to Rp16,000/USD. For Indonesians, the rupiah depreciates against the US dollar. They have to exchange Rp16,000 to get 1 US dollar, greater than before (Rp15,000).
But, for Americans, their currencies appreciate against the rupiah. They can get more rupiah for the 1 US dollar they hold (from Rp15,000 to Rp16,000).
Next is currency appreciation. Assume the rupiah exchange rate against the US dollar moves from Rp15,000/USD to Rp14,000/USD. Indonesians say that their rupiah appreciates. That’s because, with only Rp14,000, they can get one US dollar, lower than before (Rp15,000).
Conversely, for Americans, their currencies depreciate. With 1 US dollar, they get less rupiah (from Rp15,000 to Rp14,000).
Why exchange rate is important
Changes in exchange rates can affect the prices of imported and exported goods. International trade involves not only goods and services, but also some currencies as a means of payment. Thus, when the price of the domestic currency against the currencies of partner countries changes, it also affects the prices of goods and services.
The effect of the exchange rate on trade has increased in the last few years. Increased globalization and improved technology have increased the number of businesses that buy and sell abroad. These businesses need to consider exchange rates when buying and selling goods. Because exchange rates affect the prices of goods and services, it also impacts the income and costs (and profit) of the company.
The impact is even more significant when a country’s economy depends on international trade. When the domestic currency depreciates against the partner country’s currency, it means the price of imported goods becomes more expensive. Domestic businesses pay more to get the same amount of goods. Therefore, they will tend to reduce imports.
Higher prices also contribute to domestic inflation. Some goods, such as raw materials and capital goods, come from abroad. When their prices rise, it also increases the cost of domestic industrial production. To maintain profits, producers pass the increased costs on the selling price. As a result, inflationary pressures have increased. We call this phenomenon to imported inflation.
On the other hand, depreciation makes domestic goods cheaper for overseas buyers. They have to pay less to get the same quantity. As a result, exports tend to increase.
Because imports tend to decline and exports tend to rise when depreciated, it will improve the trade balance. The improvement in the trade balance will ultimately lead to higher economic growth due to increased aggregate demand.
The opposite condition also applies when the domestic exchange rate appreciates the currency of a partner country. Exports tend to be depressed, while imports tend to increase. It contributes to weakening domestic economic growth.
Please note, we discuss the effect of changes in the exchange rate by assuming other factors are constant. In fact, international trade depends not only on the exchange rate, but also inflation, the competitiveness of goods, and elasticity of demand.
Nominal vs. real exchange rate
The nominal exchange rate refers to the actual value that we get in currency exchange. For example, a nominal of Rp15,000/USD means we can get 1 US dollar for the Rp15,000 we have.
That is different from the real exchange rate, which refers to the nominal exchange rate adjusted for changes in purchasing power. We can calculate the real exchange rate as follows:
Real exchange rate = Nominal exchange rate x (Foreign inflation/Domestic inflation).
We usually use the Consumer Price Index (CPI) as an indicator of inflation. For example, if in 2010, the United States and Indonesia CPI were equal to 100, and the exchange rate was Rp14,000/USD. Four years later, it was Rp12,000/USD. In the United States, the CPI increased to 110 while in Indonesia, the CPI increased to 112. Thus, we calculated the real exchange rate as 12,000 x (110/112) = Rp11,786/USD.
Why is the real rupiah exchange rate lower than its the nominal? This is because Indonesia’s inflation is higher than inflation in the United States.
- Inflation in the United States = (110/100) -1 * 100% = 10%
- Inflation in Indonesia = (112/100) -1 * 100% = 12%
The concept of the real exchange rate is the basis for calculating purchasing power parity (PPP). PPP emphasizes that identical goods should have the same prices in various countries. Thus, variations in exchange rates do not distort the comparison.
Exchange rate determinants
In a flexible regime, the exchange rate depends on the demand and supply conditions in the foreign exchange market. The main factors affecting currency demand and supply include:
- Interest rate
- Balance of trade
- Government debt
- Political risk
- Economic growth
In general, the current account surplus, low inflation, high-interest rates, low government debt, stable politics, and bright economic prospects tend to lead to an appreciation of the domestic currency relative to foreign currencies.
Usually, countries with low inflation will see their exchange rates appreciate. Inflation represents an increase in the level of prices of goods in general in a country. Therefore, low domestic inflation makes domestic goods more competitive in the international market. The demand for exports is high, so is the demand for domestic currencies.
Conversely, countries with high inflation will see their currencies depreciate. Domestic goods are less competitive because prices are rising high.
Domestic interest rate spreads against international interest rates affect capital flows. High domestic interest rates relative to international financial markets increase capital inflows. Investors see the domestic economy offering higher returns to foreign lenders. The entry of foreign capital will cause the exchange rate to appreciate.
Conversely, relatively lower interest rates cause the exchange rate to depreciate. Capital leaves the country and goes to higher-returns countries.
As discussed earlier, international trade requires payment. This payment involves currency exchange. Therefore, the trade balance affects the exchange rate of the domestic currency.
If exports exceed imports (trade surplus), demand for the domestic currency increases. As a result, the domestic currency appreciates.
Conversely, when the domestic economy experiences a trade deficit (imports exceed exports), the exchange rate will tend to depreciate. A deficit means that the country needs more foreign currency to pay for imported goods than is collected from exports.
The question is whether the exchange rate affects the trade balance, or does the trade balance affects the exchange rate? Economists explain it through the J-Curve. The trade deficit initially causes the depreciation of the domestic currency because imports are greater than exports. Depreciation will continue until domestic goods and services are cheap enough for foreigners, thereby increasing exports.
When the price of domestic goods becomes cheaper because of depreciation, exports will increase. Conversely, imports tend to fall because the price of foreign goods becomes more expensive. If this happens, the trade deficit will decrease and lead to a surplus, until the price of domestic goods becomes more expensive for foreigners.
The opposite result also applies when there is a trade surplus. The surplus ultimately leads to appreciation, which makes the price of domestic goods more expensive and the prices of imported goods cheaper. Appreciation reduces the surplus because exports will tend to weaken, and imports tend to increase.
As a result, the exchange rate will ultimately direct a country’s trade balance towards its balance. That will happens only when the exchange rate moves freely. For this reason, some economists favor a flexible exchange rate rather than a fixed exchange rate.
When government debt is high, it increases the risk of default. The higher the risk of default, the more likely foreign capital will leave the domestic capital market. When defaults lead to capital flight, this can cause a sharp depreciation of the domestic currency.
Fluctuations in exchange rates, in certain situations, do not always reflect a country’s economic fundamentals. This can be caused by speculative activities. Speculators will usually take every opportunity for short-term profits. In addition to causing currency exchange rates to become more volatile, speculative activities can also lead to a financial crisis, as happens in Asia during 1997-1998.
Stable politics support the investment climate, especially in terms of the economic policies adopted. A favorable investment climate makes investors more confident to invest their capital.
Conversely, political turmoil can damage investor confidence. Political instability and poor economic prospects can cause a massive capital flight, leading to the depreciation of the domestic currency.
Foreign investors will usually look for countries with healthy economic growth. Strong economic performance offers opportunities for higher returns and encourages foreign investors to enter. Positive capital inflows appreciate the domestic currency.