1- Exchange rates are described as the price of one country’s currency in relation to another. Exchange rates may be expressed as the average rate for a period of time or as the rate at the end the period (Peter, 2011). Exchange rates are classified by the International Monetary Fund in three wide characteristics indicating the role of the authorities in the determination of the exchange rates and the increase of exchange rates in a country (Peter, 2011):
- The market rate that is utilized to describe exchange rates determined largely by market forces
- The official rate that is used to describe the exchange rate determined by authorities
- The arrangement falling between the two, in which the rate keeps a stable value against another country or a composite of currencies.
Interest rates, on the other hands, is the dollars paid by a borrower to a lender for use of funds over a specific period of time. It is usually expressed as a percentage of the principal borrowed per time period (Glantz et al., 2014). In addition, the total interest rate element is related to as the nominal interest rate that consists of two parts: real that represents the actual profit or gain received by the lender and inflation that represents the overall increase in economic cost (Glantz et al., 2014).
Furthermore, the relationship between nominal interest rate differentials and exchange rate movements is compound. The associated cash flows do not depend on the nominal interest rate differential , but on the adjusted amount for the expected rate of depreciation or appreciation of the foreign exchange value (Batten et al., 2012). In addition, the developing capital flow and the future change in the exchange rate will arise only if the higher nominal interest rate in one country is not redeemed by an expectation of an equal-sized depreciation of that country’s currency (Batten et al., 2012). As a result, the expectation of future appreciation or depreciation of a currency is correlated to the expectation of future inflation in one country in regard to another country. (Batten et al., 2012).
References
Batten, D, S., & Thornton, D, L. The discount rate, interest rates and foreign exchange rates: an analysis with daily data. Journal of International Money and Finance. 279-292. The Discount Rate, Interest Rates and Foreign Exchange Rates: An Analysis with Daily Data (stlouisfed.org)
Cornelius, P. (2011). Exchange rate. International Investments in Private Equity. 203-225. https://doi.org/10.1016/B978-0-12-375082-2.10010-2
Glantz, M., & Kissell, R. (2014). Foreign exchange market and interest rates. Multi-Asset Risk Modeling: Techniques for a Global Economy in a Electronic and Algorithmic Trading Era. Academic Press. https://doi.org/10.1016/C2012-0-00800-9
2- Exchange rates have been around for some time. Exchange rates have helped U.S. businesses and international businesses stay intact when it comes to converting money by the dollar. The exchange rate also has rules set in place to keep the chaos at a minimum. When something happens in our economy it looks like a stack of dominos that have just fallen. Everyone and everything will be affected by it. “Exchange rate has factors like the interest rate, economic growth, and relative inflation rates(Pettinger,2020).” If anyone of these factors would decrease or increase it would have some kind of effect on the exchange rate. For example, let’s say my clothing business has increase sales and now I am becoming more competitive with other brands. There will be a higher demand for my product which would cause an increase in the dollar value. Now if sales are not good and they start to decrease then this will cause a decrease in value for my product. Exchange rates work similarly.
Right now, at my job, our customers who live in Nigeria are experiencing an increase in the exchange rate. This means it is costing our customers more money than usual to import cars into their country. The exchange rate for Nigeria is at its highest, and because of this, our customers are shipping less. This then will cause a decrease in our sales. Sometimes it can be things that are happening in the other countries that can affect our profit in the U.S. Just like any other business International business has its ups and downs as well.
With all this in mind, the real question is does interest rate differential predict exchange rates? Before we can answer this question, we must know the difference between interest and interest rate differentials. “According to Brown University interest rate is the sum charged by a lender to a borrower for the use of assets, expressed as a percentage of a principal(Brown University).” An interest rate differential is when you weigh the interest rates between two interests that are similar that are interest-bearing assets. When interest rates are high in a country it means that country’s currency or money values is at a high than a country that may have a lower interest rate. So, the interest could have an impact on the exchange rate for that country, but that doesn’t mean it determines or pick the rates. For example, Nigeria went through an exchange rate change due to the economy reliant on oil. This would cause a change in rate due to the drop in oil. The decrease in oil supply for this country is what changed the rate. Now that they have less to no oil their value has gone down. In this cause interest rate differential may or may not matter due to the country having a change in the economy. I believe it comes down to what kind of economic events and other factors is going on with the country at the time.
Resources
Brown University. Understanding Interest | Loan Office. (n.d.). https://www.brown.edu/about/administration/loans/understanding-interest.
2021•Nigeria, J. 19th, Games, D., Thomas, D., Ngila, F., Thomas, D., Kedem, S., & Magazine, A. B. (2021, July 20). Nigerian businesses groan as naira devaluation bites economy. African Business. https://african.business/2021/07/finance-services/nigerian-businesses-groan-as-naira-devaluation-bites-economy/.
Pettinger, T. (2020, March 10). Factors that influence the exchange rate. Economics Help. https://www.economicshelp.org/macroeconomics/exchangerate/factors-influencing/
3-Hi Professor and classmates,
To begin with, Exchange rates are determine based on multiple factors. For example, one county can fixed or flexible exchange rates depending on their fiscal or monetary policies. Fixed exchange rates are put in place because a government is requiring the country to follow restrictive monetary and fiscal policies. On the other hand, this can create economic disasters like increase unemployment rates and slow down economic growth. Although fixed rate can help decrease inflation rate. In addition to, governments utilize fixed exchange rates to balance their government spending and foreign exchange reserves.
Moreover, when a country wants to reduce risk with their currency, they utilize a floating exchange rate system where a government pegs its currency with another country. For example, a country A will set their exchange rates with the U.S dollar since the US has great tracking record and over 80% of the world uses dollars for trading purposes. In addition to, supply and demand of goods and services can dictate a flexible exchange rate of a country. For example, the exchange rate pass-through technique utilizes the purchasing power party to calculate a country exchange rate.
According to Christy, we have other factors that affects exchange rates like money supply. Government official will have access to their monetary cash on hand, which it influences both inflation and exchange rates. Thus, the money supply is kept on the country’s central bank. A few things to watch are how much money is in circulation because it can cause inflation, and it can determine how much worth is the country’s currency worth.
Reference
Eiteman, D. (2020). Multinational business Finance, Global Edition. Pearson Education Limited.
Lowry , C. (2021, August 23). How to calculate exchange rates: Blog: Western union. Blog | Western Union. https://www.westernunion.com/blog/us-how-to-calculate-exchange-rate/.
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