Exchange rate concepts

by **claud39** on Thu Jan 07, 2021 10:10 am

Exchange rate concepts

01/07/2021

Use works that are open and operating in one country , the local currency to pay for the costs of production and wages of employees, and accrued interest on loans, and perhaps the distribution of profits to partners. However, companies that operate in multiple countries may sell their products in different currencies and pay their suppliers spread across far-flung countries in the currencies of those countries, and therefore they need to change the local currency to many foreign currencies.

It is also well known that companies and countries use the international financial system to borrow in foreign currencies. The best example of this is the Iraqi government issuing treasury bonds denominated in dollars that it sells in the American and European financial markets to borrow amounts in dollars to fill the Iraqi budget deficit. When countries and companies use foreign currencies, they have to deal with changes in the exchange rate.

In this article, we will review some basic concepts related to the exchange rate, the change in the currency rate, the nominal and real exchange rate, as the beginning of a series of articles related to this vital matter, so that the reader is better informed about concepts that have been mixed in the media, which causes distortions in the understanding of the topic and its effects on the economy.

The nominal exchange rate

Also called the exchange rate for convenience, it is the price of one unit of one currency in the equivalent in another country's currency. For ease of use, we express the nominal exchange rate as the ratio of the number of units of foreign currency against one unit of local currency. For example, we say one dollar for 1,450 Iraqi dinars. On the other hand, we express the nominal exchange rate in Iraq by saying that every Iraqi dinar can be exchanged for 0.0007 dollars.

Fluctuations in the exchange rate can play an important role in determining the ability of companies to sell their products to other countries and on the prices that local consumers pay for imported goods and commodities. Take, for example, a bag of rice that is exported from the United States to Iraq. If the price of a bag of rice in the United States was 50 dollars, then its price in Iraq would be 72,500 dinars, if the exchange rate was 1,450 dinars per dollar. But if the exchange rate of the dinar decreased against the dollar and became 1,600 dinars per dollar, the price of a bag of rice would be 80,000 Iraqi dinars. Although the price of the bag of rice has not changed in the United States, the decrease in the Iraqi dinar exchange rate (about 10%) will cause the American exporter to lose some of his sales in the Iraqi market due to the high domestic price of the goods he exports to Iraq.

Likewise, due to the depreciation of the dollar's exchange rate against the Japanese yen between 2008 and 2012, many Japanese automakers faced a decrease in their sales of cars exported to the US market. In order to avoid the risks that include selling cars against the dollar while bearing the cost of production in Japanese yen, these cars have established factories to produce their cars in the United States itself.

As exports have become a large part of the gross domestic product of most countries of the world, fluctuations in the exchange rate increasingly affect local economies. It can result in any increase in the exchange rate resulting in a significant decline in exports to reduce domestic production companies and laying off some workers. It is not surprising that important economic publications around the world publish exchange rate data and articles on the effect of exchange rate movement on corporate sales and production. Economists and policymakers are closely watching the movement in the exchange rate due to its effect on the economy in general.

The immediate exchange is made between two currencies according to the current exchange rate or what is called the spot exchange rate. Buyers and sellers of currencies can also agree today to exchange currencies at a later date based on a forward exchange rate. The agreements to exchange currencies in future times are called futures swaps and futures swaps.

Forward swap contracts are negotiated between two financial institutions, usually commercial banks. For example, the Bank of Baghdad agrees with a US bank today that after 90 days, it will buy $ 100 million for Iraqi dinars at an exchange rate of 1,450 dinars to the dollar. Whereas futures exchange contracts are made to exchange financial products such as stocks and bonds by people in the markets for exchanging those products, such as the Chicago Mercantile Exchange. Details of futures contracts, such as the amount of currency that each contract contains and the time that the contract expires, are formulated by the management of the market in which the contract is made. The existence of futures and futures contracts allows companies to hedge or reduce the risk of losses that can result from exchange rate fluctuations.

For example, the Iraqi Oil Export Company (SOMO) might suffer some losses if the exchange rate of the dinar rose against the dollar. Suppose that SOMO sells an oil shipment to an American company for an amount of 50 million dollars, and it is agreed that the American company will pay the amount after 90 days when the shipment is delivered. SOMO faces some risks, or the so-called exchange rate risk, as the exchange rate of the dinar may rise against the dollar in the ninety days between the agreement to sell and the receipt of the payment. If that were to happen, SOMO would receive less Iraqi dinars for the $ 50 million. By entering into a forward exchange rate contract at the time of the sale agreement, SOMO can fix the exchange rate to a certain percentage in which it can exchange the dollars that you will receive after 90 days for it, and accordingly reduces the exchange rate risk. Usually companies do not write forward exchange contracts themselves, but rather rely on specific banks to provide these services for a fee.

Each currency has an immediate exchange rate against every other currency, or what is called the binary exchange rate. Economists and policymakers see more benefit in looking at the multiple exchange rate, which shows the price of one country's currency against a group of other countries' currencies. This group of currencies is called the basket of currencies and usually includes the US dollar, the British pound, the euro, the Swiss franc, the Japanese yen, the Canadian dollar, and possibly other currencies. Each currency in this basket is given a weight according to the amount of trade exchange between the countries of those currencies and the country of origin. In this case the exchange rate is referred to as a semantic number, not a direct price. And like any other indicator, what matters is the movements of the multiple exchange rate over time rather than its value at a specific time.

The dollar’s exchange rate fluctuated greatly since 1973. It increased during the eighties against many other currencies, which created great difficulties for American companies to export their products to other countries of the world. However, since 2001, the exchange rate of the dollar in the market witnessed a decline compared to other currencies, which helped American exporting companies to increase their sales around the world.

Real exchange rate

The nominal exchange rate tells us how many units of foreign currency can be exchanged for one unit of local currency. But economists and policymakers are more interested in the prices of foreign commodities and goods as opposed to domestic goods and goods. In other words, they are concerned with the terms of trade, that is, the ratio in which domestic goods and goods can be exchanged for foreign goods and goods. That exchange ratio is called the real exchange rate. The real exchange rate provides a better measure of the change in the prices of goods and commodities in a country compared to foreign goods and commodities than the nominal exchange rate provides. Therefore, when economists and policy makers try to estimate the effect of a change in the exchange rate on exports and imports, they rely on the real exchange rate and not the nominal exchange rate.

Measuring the real exchange rate using a single commodity: the PVC Mac Index

The Economist in Britain introduced the use of the PCMAC index in September 1986 as an index of purchasing power parity of currencies. The index is based on the logical assumption that two different processes should naturally adapt until the cost of an identical basket of goods and commodities becomes the same in the two currencies. Accordingly, the McDonald's company called Your Mac sandwich was chosen to represent this basket of goods and similar goods because it is available in a largely identical way in many countries of the world. Therefore, the index helps to compare the currencies of two different countries.

If we take, for example, the price of a sandwich in the United States is five dollars, for example, and in Iraq, seven thousand dinars. Meanwhile, the nominal exchange rate between the two currencies is 1,750 dinars to the dollar. In order to calculate the real exchange rate, we have to find the number of Iraqi sandwiches that can be exchanged for one American sandwich. We can achieve this in two steps. First, we use the nominal exchange rate to convert the price of the US sandwich into Iraqi dinars. The second step is to divide that by the price of the sandwich in Iraq in Iraqi dinars, to get to the number of Iraqi sandwiches that buy one American sandwich. Which:

The real exchange rate = 1750 dinars per dollar * 5 dollars for the American sandwich / 7000 dinars for an Iraqi sandwich = 1.25 Iraqi sandwiches for every American sandwich

That is, your Mac sandwich in the United States, given the prices in the two countries and the nominal exchange rate in mind, can buy a sandwich and a quarter of similar sandwiches produced in Iraq. It is worth noting that the real exchange rate tells us how much foreign goods and commodities one unit of domestic goods and commodities can buy. That is, we can measure the real exchange rate through the exchange of goods and commodities instead of currencies.

Usually we do not measure the real exchange rate using the price of a single commodity but using the average price, or the general price level, in each country. Accordingly, a simple equation can be constructed to compare the local rate and the average prices in the other country with the nominal exchange rate to determine the real exchange rate as follows:

Real exchange rate = nominal exchange rate * (domestic rate / foreign rate)

For example, if the real exchange rate of the Iraqi dinar is 1,500 dinars per dollar, then that value indicates that an ordinary commodity produced in the United States could buy 1,500 units of a similar ordinary good produced in Iraq.

The real exchange rate and the nominal exchange rate move symmetrically only if the ratio of the domestic price rate to the foreign rate rate is nearly constant. This clearly indicates the risks of a large rise in domestic prices, that is, inflation, compared to inflation in the other country on a change in the real exchange rate.

* Professor of Economics and Political Science, Kansas State University, USA.

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