Essay on Foreign exchange rate

Foreign exchange rate (or simply exchange rate) is the rate which is used for exchanging one currency for another one. Apart from enabling people to convert their money and allowing them to travel and conduct business overseas, foreign exchange rates are an essential element in the global economy, since they help to maintain the balance of capital and trade balance worldwide. Foreign exchange rates are directly affected by inflation, real interest rates, trade and capital balance in a particular country. Exchange rates influence many factors related to global economy and business, such as competitive position of products, attractiveness for investment, capital preservation opportunities, etc.

These rates have a significant impact on economical health of the country, because these rates influence the efficiency of financial instruments, determine the strength of the currency, regulate import and export levels and have an impact on the prices of products and services within the country. Investment flows are also strongly affected by foreign exchange rates. In general, it is possible to see that foreign exchange rates have a rapid impact on inflation, economic growth, employment and even GDP level.

Key participants of global financial market are U.S. commercial banks with overseas operations and/or deposits in foreign banks, foreign commercial banks and correspondent banks (Madura, 2008). Their transactions and fluctuations of exchange rates determined by the relation of supply and demand for currencies as well as international laws and regulations. Moreover, exchange rates are one of the main factors affecting the stability of global economic system.

In international economy, the transition of money takes place for countries with low interest rates to countries with higher and inflation-adjusted rates. The increase in interest rates causes the revival in the economy, supposed that inflation rates in the country do not exceed benefits from economic growth. U.S. banks are seeking expansion opportunities and are increasing the volumes of their operations overseas. Although not all global markets are equally open to U.S. foreign banking, there are plenty of new opportunities for them in the global economic system.

US monetary institutions are eligible to intervene into the foreign exchange market in case of disorderly market conditions (Mishkin, 2007). There are two major organizations responsible for dealing with foreign exchange market: the Treasury and the Federal Reserve System. The responsibility of the Treasury is to regulate the US policy of exchange rates, while the Fed is responsible for foreign exchange market intervention. In 1970s-1990s, it was believed that exchanged rates had reflected the overall state of the economy (Mishkin, 2007), and interventions were quite often. However, it was found out that the results of interventions are not the same as predicted, since there are many factors influencing the dynamics of foreign exchange market. Currently the central bank influence on foreign exchange rates has become quite occasional.

The decision of the central banks to adjust the value of the currency might be determined by the necessity to influence economic conditions. If the economy needs stimulation, for example, the central bank might weaken the dollar: as a result of declining dollar, exports will grow, and economical revival will take place. However, monetary decisions on weakening the dollar should be carefully implemented because it might also increase inflation and result in deepening the recession. In order to reduce inflation and increase foreign competition compared to the domestic environment, the central bank might decide to strengthen the dollar.