Understanding Currency Exchange Rates

Before examining the concept of currency exchange rate, I think I can briefly talk about its history. The currency exchange rate is not only an indicator that expresses the value of a country’s currency in terms of other country’s currencies, but also a unique asset value. The new process that began thus increased academic and political discussions on the determination of exchange rates. In this process, the importance of concepts and issues such as the exchange rate system to be preferred, the determination of exchange rates, the explanation and prediction of changes in currency exchange rates, exchange rate crises, etc. has increased. 

The dimension that international financial relations have reached today has made it impossible for countries to follow currency exchange rate policies that are isolated from the world or do not take global dynamics into account. 

Factors such as the increasing influence of emerging market economies, the differentiation of global trade patterns, the significant increase in trade volumes and capital flows, and the structural transformation in production and factor markets have dragged international financial relations into a different and competitive environment. The transformation in the regional and sectoral composition of international trade flows has increased the importance of currency exchange rates for both countries and international integrations.

What Are Currency Exchange Rates And How Are They Determined?

Until the 1980s, when the foreign exchange buyer was defined as an importer who wanted to buy goods from abroad and the foreign exchange seller was defined as an exporter who sold goods abroad, there was a very close relationship between the supply and demand for foreign exchange and the import-export tendency, but today, capital movements for trade, investment, protection or speculation have constituted the vast majority of transactions in foreign exchange markets. 

Markets have become a single market structured with a globally developed information and communication network and integrated through international arbitrage movements. In this context, when the diversity of economic and social factors is taken into account along with globalizing financial dynamics, it is seen that traditional and modern theories and models regarding currency exchange rate movements are insufficient on their own to explain changes in exchange rates. 

The exchange rate is a fundamental factor in terms of the factors that determine the external balance (balance of payments) and internal balance (such as price stability, full employment, and development) of an economy.

How Do Currency Exchange Rates Affect Global Trade?

The exchange rate is an important macroeconomic factor underlying international trade. Exchange rate uncertainty can weaken the flow of trade because both investors and traders prefer more stable exchange rates. Therefore, exchange rate uncertainty not only affects the decision-making processes of traders and investors but also destabilizes capital movements and trade volume. 

The effects of exchange rate fluctuations on imports and exports are examined in three different time periods. In the long term, exchange rate uncertainty affects the long-term decision-making process by affecting the volume of imports and exports, investment allocation, and government purchasing-selling policies. In the medium term, exchange rate volatility affects the medium-term economic outlook by affecting the balance of payments and the level of economic activity. In terms of short-term effects, exchange rate fluctuations affect local traders and consumers because they affect commodity prices. Exchange rate instability presents opportunities for local investors to invest in foreign currencies such as the US dollar, which can lead to an appreciation of the dollar and a depreciation of the local currency. This can affect the prices and volume of imports and exports as the local currency weakens.

The end of the fixed currency exchange rate system and the increasing impact of the financial globalization process in the 1970s affected the factors determining exchange rates and made them more complex and dynamic.  In this new and unstable period, new approaches were created that adapted to the processes determining exchange rates by taking into account the interaction of real and financial factors as well as future expectation models and psychological factors. 

These are; the interest rate parity approach, overshooting approach in currency exchange rates, efficient markets approach, adapted expectations approach, rational expectations approach, safe haven effect approach, speculative bubbles approach, and microstructure approach of the foreign exchange market.

What Are The Main Factors Influencing Currency Exchange Rates?

According to the Foreign Trade Flows Approach, the value of a country’s currency is determined by its foreign trade balance sheet, and when the foreign trade balance sheet is in surplus, the foreign value of the national currency increases; when it is in deficit, it decreases. Thus, factors affecting foreign trade such as relative prices of domestic and foreign goods, domestic and foreign real income increases, consumer preferences towards domestic/foreign goods, technological progress, increases in factor stocks, etc. also affect the value of a national currency. 

For example, a real income increase in a country increases the demand for imported goods (depending on the income demand elasticity of imports), thus increasing the currency exchange rate. Purchasing Power Parity (PPP), which is the main method for determining exchange rates, is, in its most general definition, an approach that suggests that the exchange rate changes recorded between the currencies of two countries within a certain period of time are determined according to the difference recorded in the relative price levels of the two countries in question. The PPP approach, which focuses on price level changes as the primary determinant in exchange rate movements, is also defined as the “inflation theory of currency exchange rates” in this respect. The extent to which international capital flows have reached with financial liberalization has revealed the inadequacy of traditional approaches based on current accounts. 

While it is expected that the currency of a country with a foreign trade deficit will lose value, on the contrary, it has been observed that this currency has gained value, and many traditional approaches have been inadequate in explaining these and similar subjective situations. Thus, asset market-based models that include monetary theses and take into account a series of dynamic elements such as future expectations have been developed. 

The growing volume of international capital flows, which has surpassed trade flows, has shifted the center of gravity in scientific analyses from flow variables to stock variables. Naturally, any approach that attempts to analyze changes in currency exchange rates will reach different results for economies with different levels of development. 

How Can You Make Money From Currency Exchange Rate Fluctuations?

One of the most well-known methods of making money from currency exchange rate fluctuations is trading in forex markets. Forex is the abbreviation of the word ”foreign exchange”, which refers to the conversion of two countries’ currencies into each other. Forex is the international foreign exchange market open 24/5. 

This market, which is the most liquid market in the world, is an over-the-counter spot market in its simplest definition. In this market, products are bought and sold at the current market price according to supply and demand and change hands between two parties without any strict legal regulation or intermediary. 

In forex markets, products such as commodities, currencies, and index contracts change hands constantly and simultaneously. In this transaction, the parties are various actors such as banks, private and public institutions, speculators, those who trade for hedging purposes, and central banks. Since there is no general regulator in forex markets worldwide, it can be said that there is no single price, especially in currencies. These price differences sometimes attract those who trade for arbitrage to this market.

What Is The Difference Between Fixed And Floating Exchange Rates?

The two extreme systems are called the “fixed exchange rate system” and the “flexible exchange rate system”. However, it is seen that mixed regimes with different contents are created in the middle of rigid fixed exchange rate systems and the most extreme flexible (free, floating) exchange rate systems. These systems are mixed exchange rate systems obtained by combining certain features of fixed and flexible currency exchange rate systems. The basic mechanism that prevents an actual external imbalance in the fixed exchange rate system is automatic balancing. 

Changes in macroeconomic indicators such as price, income, and interest rates cause changes in the current account and capital movement account. The balancing in question, which is explained by price changes by classical economists, is explained by income changes by the common approaches. When the role of capital movements caused by changes in interest rates is also taken into account, it is seen that the operation of the automatic balancing mechanism is not one-dimensional. 

The flexible exchange rate system refers to the system in which the value of the currency of any country fluctuates according to the supply and demand in the foreign exchange market. This means that a potential deficit or surplus recorded in the balance of payments is automatically balanced by the depreciation/gain of the currency of the country in question. 

The aim of the transition from fixed regimes to flexible currency exchange rates was to provide the freedom required by the globally blocked system and to ensure that this transformation would lead to a series of positive developments in economic terms. In this context, the transition to a flexible exchange rate system was paved in March 1973, and the decision-making authority in determining exchange rates was, in a sense, taken from the hands of central banks and transferred to the markets.

How Do Central Banks Impact Currency Exchange Rates?

Central banks’ foreign exchange interventions can be carried out for purposes such as affecting the level of exchange rates, reducing the volatility of currency exchange rates, reserve accumulation policies, and providing liquidity to the foreign exchange market. However, the interventions carried out by central banks with the aim of affecting the level and/or volatility of exchange rates can also have effects opposite to their objectives. 

While interventions aim to eliminate short-term fluctuations, on the contrary, an increase in volatility may be observed or situations may occur where the interventions do not have a significant effect in terms of affecting volatility. In addition, although a policy of not affecting the level of currency exchange rates has been adopted, interventions may produce effects such as an increase or decrease in the level. In this context, the need to investigate the extent to which central bank interventions are effective also arises.

Interventions of central banks; 

1) It can be covert or overt,

2) It can be carried out by a central bank alone, while sometimes it can be carried out by multiple central banks of developed countries acting together to affect the same exchange rate, 

3) It can aim to affect the currency exchange rate in the opposite direction (leaning against the wind) or to strengthen the current direction (leaning with the wind). 

Interventions are classified as sterilized and unsterilized interventions. In unsterilized interventions, the monetary base changes. Sterilized interventions, on the other hand, do not affect the monetary base. With sterilization, the effects that interventions may have on monetary policy are prevented.

How To Find The Best Currency Exchange Rates For Your Needs?

Finding the most suitable currency exchange rate for your needs varies at different times and under different conditions. Unexpected external developments that will cause volatility in exchange rates may include fluctuations in foreign markets, war, increase in oil prices, etc., while internal developments may include changes in the management style, civil war, political instability, etc. Following such a development, in cases where the country’s industry is highly dependent on foreign inputs, the increase in exchange rates will bring an increase in the input prices used by the industry, which will also lead to an increase in production costs. 

The reflection of the increase in costs on product prices will also cause other industrial branches affected by the high forward and backward connections of this industrial branch to face an increase in input costs, and the inflationary process will gain momentum. The fact that domestically produced goods are expensive will also cause exported goods to be expensive and will lead to a decrease in exports, thus the slowdown in exports while the increase in imports continues will increase the balance of payments deficit. 

Since the widening gap between imports and exports will also create pressure on exchange rates, the process that begins with exchange rate fluctuations will create a cycle of exchange rate increases – price increases – balance of payments deficit increase, and exchange rate increase again. If this reflection process continues at mutual and increasing rates, there will be large and unpredictable deviations in basic economic indicators and the country will enter an environment of economic instability.

How Do Currency Exchange Rates Impact Investments And Savings?

Foreign currency exchange rates and investments are a method that has been increasing in recent years and is used by many people to make a profit. High incomes can be obtained thanks to foreign exchange investments. When most people say foreign exchange investment, they usually think of the dollar and euro currencies. However, there is another thing to know. Foreign exchange investments are an area that covers the currencies of almost all countries in the world.

When foreign exchange investments are made, various steps must be followed. These steps are generally for mastering the fluctuations in the foreign exchange market and knowing the currency to be invested. Demo accounts should be used before foreign exchange investments. 

In this way, information about the functioning of the market can be obtained. It is necessary to follow various banks. There are also differences in the foreign exchange processing rates of different banks.

How Are Cryptocurrency Exchange Rates Different From Traditional Currencies?

Cryptocurrencies are considered money to the extent that they allow for exchange between two parties and act as a store of value. However, they also offer features that the traditional monetary system currently cannot offer. Cryptocurrencies can be spent and purchased by anyone, anywhere, anytime, without the need for a bank or government in the world. This is the most innovative feature of cryptocurrencies.

Also, fiat money is equal to debt. When a central bank issues banknotes, it simultaneously issues you, the consumer, a percentage of your government’s debt. So what does this mean? For example, consider how the EU and the US issue money.

Most of the money a government issues is when loans are taken out. When people borrow money, banks print money. Let’s take the US dollar as an example: If there were no loans, there would probably be no dollars in circulation. In other words, if consumers did not borrow money from banks, there would be no US dollars in the world.

While fiat money seems to derive most of its value from debt, this is not the case with Bitcoin. Bitcoin has a value beyond the trust of its community. Bitcoin is not based on a debt system, and Bitcoin’s value is based on how effective it is as a medium of exchange. Cryptocurrencies can be purchased and spent by anyone, anywhere, anytime, without the need for a bank or government. This is what makes them so innovative.

What Tools And Platforms Can You Use To Track Currency Exchange Rates In Real-Time?

Recently, many people in our world have turned their eyes towards currency exchange rates. If you are looking for a good application or website to track exchange rates, you may be wondering which one is the best. Thanks to many websites or mobile applications, you can view a wide range of global and local financial instruments, and follow not only exchange rates but also the status of stock exchanges, cryptocurrencies, stocks, bonds, bonds, and much more in real-time. In addition, most of these applications offer commentary and news services.

To put it bluntly, changes in exchange rates affect our lives completely and stand out as the most important factor in our purchasing power. For this reason, the platforms I follow can be even more important.

See you in the next post,

Anil UZUN