Money and Exchange Rates
Money and Exchange Rates in the Long Run
Exchange rate refers to the value of a currency when converted to the currency of another country or region. Exchange rates are critical to numerous economic activities and have been a critical part of economic policy discussions for several decades now. Investors are careful to find out the impact of changes in exchange rates on their international portfolios (Zhang, Lowinger, & Tang, 2007). Tourists are always keen to know the value of their currency when converted to the currency of the nations that they intend to visit. It is important for countries to forecast exchange rates to determine the performance of a nation’s economy in the international arena. One of the main theories used in the prediction of exchange rates is the purchasing power parity (PPP), which states that exchange rates reflect the general price level changes in the long run (Al-Gasaymeh & Kasem, 2016). Therefore, if Country A experiences higher inflation rates that Country B, Country A’s currency will depreciate when compared to Country B’s currency in the long run. Hence, the exchange rates of two different countries are at equilibrium when their purchasing power of a similar basket of goods and services is the same in both states.
Money and exchange rates, in the long run, allow experts to view different countries using a common reference point. The PPP theory indicates that the prices of the same basket of goods can be used to determine the exchange rates between two currencies in the long run. However, it is important to note that some goods and services are not exchanged in the international market and cannot be used in the determination of long-run exchange rates. For example, haircuts and land cannot be exchanged internationally, which means that their value in one country does not have to reflect the value in another nation (Al-Gasaymeh & Kasem, 2016). Hence, there would be no reason as to why the prices of such goods in one country are the same as in another nation. The price of a haircut, for example, could also be affected by cultural values. Members of a particular community might place a lot of value on a beautiful haircut, while people in another society would view the same service as not necessary. At the same time, prices of commodities such as land can depend on factors such as availability and productivity. Therefore, the long-term behavior of prices of such commodities cannot be reliable in determining money and exchange rates in the long run.
However, as PPP implies, if the prices of internationally exchangeable goods increase more rapidly in Country A when compared to Country B, Country A’s currency will be depreciating faster than Country B’s. For example, a comparison between prices of commodities in Great Britain and the United States between 1975 and 2005 shows implies that Britain’s currency depreciated against the United States dollar in the same period (Wright, 2012). In the thirty-year period, prices in Great Britain rose by about 205%, while they increased by about 142% in the United States, as shown in figure 1 below.
Figure 1: Purchasing power in Great Britain and the United States
Therefore, prices increased by about 44% more in Britain than in the United States, implying that Britain’s currency weakened against the United States’ currency. As per PPP theory, Britain’s currency depreciated by more than 20% against the United States’ currency in the same period. An analysis of the changes in prices in the two countries will show that the PPP theory does not hold in the short run. However, the long-term price changes have critical implications on exchange rates, as demonstrated by the case of Britain and the United States.
The example involving Britain and the United States shows that PPP theory does not necessarily predict the ratio at which exchange rates are affected in different countries. Consequently, two types of PPP theory come up. The first one, the absolute PPP theory, states that the exchange rate between two different currencies should be equal to the price level ratio of the two involved countries (Al-Gasaymeh & Kasem, 2016). Hence, the prices of the same basket of goods in the two countries should be exactly the same when they are converted to a similar currency. On the contrary, the relative PPP theory seeks to predict the changes in purchasing power without focusing on the levels of changes happening. In the example of Britain and the United States, the relative PPP hypothesis applies. The absolute PPP theory has many challenges because it is difficult to occur in real-life. Consequently, it is often referred to as the law of one price for traded goods. It is viewed as a modification of the PPP theory, where changes in prices of commodities are expected to occur at the same rate, thereby affecting the exchange rates at the same ratio. Therefore, the relative PPP theory is more commonly used because it allows flexibility.
Trade barriers, Preferences for domestic and imported products, and productivity levels also affect exchange rates between currencies of two countries or regions in the long run. A country that has a high preference for domestic products strengthens its currency against other nations by maintaining a high demand for locally made goods (Wright, 2012). At the same time, a preference for foreign products has the opposite impact. As a country continues to import goods from another one, its currency continues to depreciate. Productivity levels also affect currency exchange rate in the long run. When a country becomes highly productive, its cost of manufacturing and exporting products goes down. Consequently, the currency of such a nation appreciates significantly. For example, many countries in the Middle East became highly productive after the discovery of oil deposits within their borders (Wright, 2012). Consequently, the currencies of such countries have been appreciating because they can continue to produce their commodities without affecting their exports. On the contrary, lowly productive countries experience depreciation in their currency because they cannot compete against the highly productive states. Therefore, sustained productivity helps a country to enhance the growth of its currency vis-à-vis the nations or regions with which it does business. The figure below summarizes the factors that affect exchange rates in the long run.
Figure 2: Factors Affecting Exchange Rates in the Long Run
Money and Exchange Rates in the Short Run
Exchange rates undergo numerous short term changes, which can be largely inconsistent sometimes. In some instances, those changes are unforeseen because they can be caused by unpredictable factors. At the same time, some changes in exchange rates in the short run are predictable. For example, electioneering periods in any country experience a dip in economic stability. Investors are usually unaware of the outcomes of an election, making them cautious of how they use their money. Consequently, a country can experience depreciation in its currency during an elections seasons. However, most countries recover from such dips immediately after the elections are over. Similarly, several other factors can cause short-term fluctuations in the exchange rates of currencies between two or more countries. The figure below shows that the South African rand underwent several changes against the United States dollar in June 2006.
Figure 3: The Exchange rate between the United States and South Africa in June 2006
Such changes are normal, especially for growing economies that can be affected by little factors. Currencies of stabilized economies are less likely to experience short-term fluctuations when compared to developing countries. Big economies such as the United States are more likely to overcome short-term challenges than smaller ones. However, even such economies also experience currency fluctuations in the short run.
Changes in money and exchange rates in the short run are mainly caused by expectations of future direction of the relevant factors of the economy in a particular country. Investors act based on how they expect the economy of a country or region to behave in the near future (Wright, 2012). If people feel that the economy of a country will strengthen or remain stable in the future, they are confident to invest and bank their money in that nation’s currency. Consequently, the currency of that country will strengthen. However, the reverse also applies because when people have suspicions about the ability of an economy to grow, they are likely to withdraw their money and bank it in another currency. As a result, the currency of that country will depreciate significantly. However, such changes are short-lived because after a while, circumstances return to normal, and business begins to operate as usual. If the currency has strengthened unusually, it begins to fall back to its usual rate. Similarly, if it had depreciated more than expected, it begins to regain its strength. However, an economy has to respond well for a currency to regain its strength once it has lost it.
Domestic and foreign interest rates also affect money and exchange rates in the short run. When domestic interest rates are high, the demand for domestic currency increases. If foreign interest rates remain low as the domestic interest rates increase, the demand for domestic currency will continue to rise (Wright, 2012). In such a case, the domestic currency will appreciate at the expense of the foreign currency. On the contrary, when domestic interests are low, demand for local currency also diminishes. If foreign interest rates are high while the domestic interest rates are low, the demand for local currency decreases further. Consequently, the domestic currency will depreciate as the foreign currency appreciates. Expectations for interest rates also keep on changing depending on diverse factors affecting economies. As the expectations change, exchange rates also experience frequent fluctuations because people are always looking to bank their money where they will get maximum returns. Sometimes, the expectations do not materialize. In other words, people might expect domestic interest rates to increase, but they remain constant or even decrease. Such factors increase the rate of fluctuations in exchange rates because transfer of funds happens at a high rate, thereby affecting the manner in which currencies appreciate and depreciate further.
With foreign exchange markets being highly competitive and efficient, any discrepancies in returns are often short-lived. Financial markets that allow international capital mobility apply the law of one price because transactions involving large amounts of money can happen to domestic and foreign accounts almost immediately (Zhang, Lowinger, & Tang, 2007). Therefore, in a situation where the interest parity condition applies, the domestic interest rate should be equivalent to the difference between the foreign interest rate and the expected domestic currency appreciation. If foreign interest is bigger than the domestic interest, the expectation is that the domestic currency will appreciate after a while, or else all people will buy foreign deposits (Zhang, Lowinger, & Tang, 2007). Similarly, if foreign interest is less than domestic interest, the local currency will eventually depreciate; otherwise all people will buy domestic deposits, and no one will be willing to have foreign deposits. When one change happens, it is just preceding another change in the exchange rate. Hence, the domestic interest rate must be equal to the foreign interest rate added to the expected foreign currency appreciation. Therefore, there is a constant cycle of expected changes in the value of a particular currency, which leads to the unending fluctuations in money and exchange rates in the short run.
The determinants of exchange rates in the short run can be similar to the causes of the same differences in the long run. However, factors linked to short-term changes are mainly based on the expectations of how those factors will fluctuate in the future. On the contrary, long-term changes in exchange rates occur in response to what has already happened. Many experts are always monitoring economic structures in domestic and foreign markets to determine how profitable it would be to change currencies. Those expectations are the main reason for fluctuations in the foreign exchange market in the short run. When a domestic currency has high interest rates, for example, the expectation is that the interest for foreign currency will also increase to counter the effect caused by the local currency. Consequently, little frequent changes might happen to any currency. Those changes hardly have an impact on the changes that happen to the money and exchange rates in the long run. Although small economies are more vulnerable to short-term changes than the big economies, any country or economic bloc experiences some differences in money and exchange rates in the short run.
References
Al-Gasaymeh, A., & Kasem, J. (2016). Long-run purchasing power parity and exchange rates: Evidence from the Middle East. International Journal of Business and Finance Research, 10(2), 1-13.
Wright, R. (2012). Finance, Banking, and Money.
Zhang, S., Lowinger, T., & Tang, J. (2007). The monetary exchange rate model: Long-run, short-run, and forecasting performance. Journal of Economic Integration, 22(2), 397-406. https://doi.org/10.11130/jei.2007.22.2.397