Exchange rates influence activities of domestic and international companies.
Exchange rates influence many aspects of the firm's activities. For one thing, they affect demand for a company's products in the global marketplace. When the country's currency is weak (valued low relative to other currencies), the price of its exports on world markets declines and the price of imports increases. Lower prices make the country's exports more peeling on world markets. Furthermore, a company that sells in a country with a strong currency (one that is valued high relative to other currencies), while paying workers at home at its own weak currency improves its profits.
The intentional lowering of the value of the currency by the nation's government is called devaluation. The reverse, the intentional raising of its value by the nation's government, is called revaluation. Devaluation lowers the price of a country's exports on world markets and increases the price of imports, because the country's currency is now worth less on world markets. Revaluation has the opposite effects: it increases the price of exports and reduces the price of imports.
Exchange rates also affect the amount of profit, a company earns from its international subsidiaries. Translating subsidiary earnings from a weak host country currency into a strong home currency reduces the amount of these earnings when stated in the home currency.
Exchange rate factors
Two concepts are used to determine the level of which an exchange rate should be. The wall of one prize stipulates that when prices expressed in a common denominator currency, an identical product must have an identical price in all countries. For this principle to apply, products must be identical in quality and content in all countries and must be entirely produced within each particular country. The concept of purchasing power party (PPP) helps determine the relative ability of two countries currencies to buy the same "basket" of goods in those two countries. Last, although the law of one prize holds for single products, PPP is meaningful only when applied to a basket of goods.
Two phenomenon influence both exchange rates in PPP: inflation and interest rates. When additional money is injected into an economy that is not producing greater output, prices rise, because more money is available to buy the same amount of products. When unemployment is low, employers pay higher wages to attract or retain employees. Employers then typically raise prices to offset the additional labor cost to maintain profits.
In turn, interest rates affect inflation because they affect the cost of borrowing money. Low rates encourage people and businesses to increase spending by taking on debt. On the other hand, high rates prompt them to reduce the debt because higher rates mean greater debt payments. Because real interest rates -- rates that do not account for inflation -- are theoretically equal across countries, any difference in the rates of two countries must be due to different expected rate of inflation. A country that is experiencing inflation higher than that of another country should see the relative value of its currency fall.
Forecasting exchange rates
There are two distinct views regarding how accurately future exchange rates can be predicted by forward exchange rates -- that is, by the rate agreed upon for foreign exchange payments at a future date. The efficient market view holds that prices of financial instruments reflect all publicly available information at any given time. As applied to exchange rates, this means that forward exchange rates are accurate forecasts of future exchange rates. The inefficient market view holds that prices of financial instruments do not reflect all publicly available information. Proponents of this view believe that forecasts can be improved by information not reflected in forward exchange rates.
Two main forecasting techniques are based on this belief in the value of added information. Fundamental analysis uses statistical models based on fundamental economic indicators to forecast exchange rates. Technical analysis employs a technique using charts of past trends in currency prices and other factors to forecast exchange rates. Many forecasters combine the techniques of fundamental and technical analysis to arrive at potentially more accurate forecasts.
Evolution of the current international monetary system
The Bretton Woods Agreement (1944) was an accord among nations to create an international monetary system based on the value of the US dollar. The system was designed to balance the strict discipline of the gold standard, which linked paper currencies to specific values of gold, with the flexibility that countries needed to deal with temporary domestic monetary difficulties. The most important features of the system or fixed exchange rates, built in flexibility, funds for economic development, and an enforcement mechanism.
Bretton Woods created the World Bank, which funds poor nations economic development projects such as the development of transportation networks, power facilities, in agricultural education programs. It also established the International Monetary Fund (IMF) to regulate fixed exchange rates and enforce the rules of international monetary system.
Ultimately, the Bretton Woods Agreement collapsed because it depended so heavily on the stability of the dollar. As long as the dollar remained strong, it worked well. But when the dollar weakened, it failed to perform properly. The Jamaica Agreement (1976) endorsed a managed float system of exchange rates -- a system in which currencies float against one another, with limited government intervention to stabilize currencies at a particular target exchange rate. This system differs from a free float in which currencies float freely against one another without governments intervening in currency markets. It within the system, some countries try to maintain more stable exchange rates by tying their currencies to another currency stronger currency. The European monetary system (EMS) was a complex system designed by the European Union (EU) to stabilize exchange rates, promote trade, and control inflation through monetary discipline.