Exchange Rates System in Open Economy (Essay Sample)

Exchange Rates System in Open Economy
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Exchange rate refers to the rate in which a currency is changed to another. Also, it is the worth of one country’s coinage to another coinage. In simpler words, the exchange rate is the value in which two currencies are switched for one another (Verdelha, 2018). The exchange rate involves the processing of swapping currencies. These exchange rates can either be fixed or floating. Despite the market price, that is the lowest price that should be paid. Notably, properly managed lower imposed prices exchange rates determine the current international exchange rates. These managed floating exchange rates ensure that each value of a currency is influenced by the activities any authority or chief bank does economically.
In calculating the conversion rate, the original currency is divided into the new money to rate accurately. For example, if you exchange 200 dollars for 80euros, the exchange rate is 1.20. Exchange rates are grouped into three systems; fixed-rate pegged float and float (Futerman, 2020). Fixed suggests the currency is tied to another currency on the dollar and euros entirely overseen by the government. Under the fixed regime, dollarization involves the adoption of another country’s currency. Some of the banks with the best interest rates are Comerica, BB&T, and State Employees Credit Union.
For instance taking the de facto exchange rate China’s system, the exchange rate in the country is managed based on the market supply and demand and the reference to number of currencies. The one problem with the management of exchange rates is that the corresponding weights of other currencies is never revealed which makes it challenging to determine the currency basket. Moreover, even when the Peoples Bank of China is revealing the Yuan exchange rate, it refers to the basket but never a particular currency. However, there is some advantage to the management of exchange rate since the government can employ a crawling peg techniques to the US dollar such that the Yuan can also appreciate against the US dollar like other currencies.as a result “secrecy” involved, the government can easily intervene in the market when there is excessive supply or demand of the US dollar by either buying or selling (Dur et al., 2020).
Most of these countries use an adopted currency since they cannot bear the cost of running their central bank; they often use the US dollar (Dur et al., 2020). The currency union involves using a similar currency between two or more countries who share a joint central bank such as; Eurozone. The currency board focuses on a country's exchange rate, which carries a fixed exchange rate with a particular foreign currency. It follows legal and procedural rules that enhance the ties among them, such as Hong Kong against the US dollar. Float exchange system allows a value to waver as per the market events trends through supply and demand (Chen et al., 2020). Under the float exchange regime, the free float, which is also considered clean, allows the currency's value to switch without government intercession freely. However, the government manages the dirty float to alter it in the best way that fits the economy's development in case of a decrease or increase in the value of the currency.
The pegged float is labeled but can fluctuate simultaneously depending on the economy; a rate is fastened to ensure stability (Koijen et al., 2020). The currency basket peg reduces the chances of high risks during fluctuations. The crawling peg can be defined as the decrease and increase in a currency's value at a continuous rate against another currency. Exchange rates affect the business either positively or negatively. Unstable exchange rates can affect the quality of competition; when a country's currency depreciates, it increases the cost of importing, which escalates at a higher rate, giving room for domestic goods to gain an increase in profits and sales.
Generally, a higher exchange rate is better because you will get more of the foreign currency you are purchasing upon exchanging (Pantelopoulos, 2020). Admittedly, exchange rates are determined by certain factors, including interest rates, inflation, speculation, public debt, the balance of payment, and economic growth. When interest rates rise in a country, it is advisable to invest in that country since its return rate is impressive. Thus the demand for the currency will increase.
The rise in interest rates causes a hot money flow that helps find the worth of a currency. Notably, higher absorption rates cause valuation of price, whereas lower interest rates lead to depreciation. Attractive and competitive products in the market lead to an increase in exchange rates; if a country improves its labor market relations and productivity, goods become more competitive, thus causing appreciation (Mathur, 2019). When the country's inflation is lower than any other place, the goods produced in that country tend to be more competitive, thus an increase in demand for the currency.
The imports will be purchased in lower amounts since they are less competitive. In most cases, the value of public arrears would alter the exchange rates; if a market foresees the government not paying debts it borrowed, the investors dispose of their bonds to other markets, causing a fall in the exchange rates. A good example is Iceland, which had economic difficulties in 2008 that led to a drop in their currency worth. A decline in economic growth causes a decrease in the exchange rate because interest rates fall during a descent. Moreover, several factors reduce the increasing rates, such as; a country trying to restore its competitiveness after a considerable debt.
Many people who make speculations often demand more to ensure they remain relevant in the market by profitability (Nguyen, 2020). The value of a currency will rise if market news shows an increase in interest rate through predictions. Between the years 2010 and 2011, the Japanese Yen beat the other super countries like the US; despite the reduced returns rates and growth of Japan, the Yen never stopped getting better.
When the pound fell in the 1980s, it paved the way for the US dollar growth, whose strength increased the US interest rates (Lai et al., 2020). The balance of payments means that the value of imported goods is more significant than those exported; hence, if it is adequately financed, then the currency is safe, but if it does not attract adequate capital, the currency faces a depreciation. Higher growth of GDP favors the currency. The stability of a government influences currency movement; unpredicted factors may cause uncertainty of currency markets. Government involvement affects the value of a currency influences exchange rates; countries like China have involved itself in ensuring its currency is essential to make China exports more competitive. That is made possible by purchasing the US dollar distinctions, which build up the US dollars’ worth to the Chinese Yuan (Luzarraga-Goitia et al., 2020). Some countries which depend on the export of raw materials experience depreciation, especially if there is a fall in the price of raw materials; the cost of steel in Ukraine has experienced a tremendous fall. As of late, we have seen a critical decrease in China's foreign trade reserves. It has tumbled from a pinnacle of almost 4 trillion US dollars in 2014 to around trillion US dollars today. The sharp decrease in foreign reserves may be because of unexpected stops in capital inflows that are elated to concerns about China’s economic development and future.
Exchange rates are a devolved global market that makes it possible to trade currencies known as the foreign exchange market. Typically, the foreign markets determine the foreign exchange rate for each currency and encompass buying, selling, and exchanging currencies at present-day prices. Most of those who participate in the foreign exchange markets are international banks and other financial institutions. These foreign exchange markets enable the currency conversion of both international trades and investments (Engel, 2019). Additionally, the foreign exchange market is unique due to some characteristics like; it uses anchorage to promote profit and loss margins regarding the size of the account.
The geographical dispersion shows locations that provide a more significant opportunity for families regarding transportation, education, and health. Foreign exchange markets have a continuous operation reliable for 24 hours except over the weekends. There are a variety of factors that affect the exchange rates hence making them convenient. Compared to other markets of fixed income, it has low margins of relative profit. The foreign exchange market is one of the best for accurate and reasonable competition.
Several theories have been used to explain the switches in exchange rates. They include;
International parity conditions, which to some extent, provides a logical explanation for the fluctuations in exchange rates. These theories falter as they are based on challengeable assumptions that may consist of the free flow of goods, services, and capital, which hardly are right in the real world. Second, the balance of payments model or rather the Brexton Wood currency pegging: On this model, it addresses mainly goods and services that can be exchanged, leaving behind the increasing role of global capital flows (Kemp and Hylton, 2020). However, the model failed to explain the continuous appreciation of the US dollar during the 1980s and most of the 1990s, despite the US current account deficit's growth. Third, the asset market model is a model that looks into currencies as an important asset class for establishing investment portfolios.
These...