Extent to Which the Theory of Exchange Rates Explain the Performance of the US Dollars - Essay Example

of the Extent to which the theory of exchange rates explain the performance of the US$ in recent years Introduction Exchange rates can be the value, worth or price of a country’s money with respect to another country. Exchange rate can be fixed or stretchy depending on the monetary policy and the set agreement between the countries taking part in the exchange. However, an exchange rate is said to be fixed when two nations or countries come into consensus to keep a fixed rate based on their monetary policy and regulations governing these countries. Historically, the most common fixed exchange rate used to be gold standard, until 1850s where, one ounce of gold was taken as worth $20 (U.S dollars) and 4 pounds of sterling, leading to an exchange rate of $5 of every pound. On the other hand, an exchange rate is said to be flexible, variable or floating when two or more countries come into agreement of letting the international market forces govern the rate through the forces of demand and supply. In this case, the rate would vary with a country’s imports and exports. According to Marazzi, Mario & Sheets (2007) majority of the trade economies such as US, Europe, Japan and China takes place with variable and flexible exchange rates that vary within comparatively fixed limits. Therefore, there is a strong relationship between the US dollar rate of exchange and all the major foreign currencies with an exception of those from the developing countries. It should be taken into account that with respect to the US stock market, this correlation is equilibrium with all parties being significant to its sustenance. The key reason for this causal relationship is that every investor view U.S Dollar as a negative beta which should always be falling in value whenever there is an upsurge of the value of stock market and should be increasing in value whenever there is a decrease in value of the stock market. In the recent past, owing to the fluctuating value of the US currency, many investors have been reducing their demand for the US dollars whenever stock market convenes only to increase their demand later when the stock markets sell off. Measuring exchange rates Exchange rates can be determined in two ways, i.e., through Bi-lateral rates or multi-lateral rates. Bilateral rates provide the comparison of the rate of exchange of currency of a country with that of another currency of a different country. For instance, one sterling pound can exchange for $1.50. On the other hand, multilateral exchange rate is the worth of a currency compared to more than one currency, unlike bilateral rates that give the comparison of only two countries or nations’ currency. Economists and market analysts determine multi-lateral rates to decipher averagely what is taking place in the exchange rate arena. This is got through the adoption of an index that denotes variations in one currency as compared to a pool of other currencies. In the past few years, the US exchange rate has constantly made the US dollar to fall rapidly against other well-known currencies such as euro-zone currencies with the lowest limit being recorded in 2008. Exchange Rate Policy The exchange rate based on any country’s economy impacts either negatively or positively the aggregate demand via its effects on imports, exports and the extent at which policy makers can exploit this correlation. Besides, Exchange Rates can be operated as a form of monetary policy for guiding the balance of trade of many nations. In ideal situation, rates should always be held down to stimulate and scale up exports with a view of lessening inflationary pressure rocking a country’s economy. While the Bank of America does not particularly target the exchange rate, the MPC would always focus on the trend of exchange rates. In essence, during times of inflation pressure, the MPC would prefer a comparatively elevated rate given that this would lessen the price of import commodities and services and also will always help in absorbing the pressure caused by inflation. However, the American Monetary Policy Committee (MPC) must always be watchful to the export competitiveness, since when the exchange rate moves too high, the U.S export loses in demand as the value of its currency also weaken as justified by the trend of rate of trade that has recently been witnessed in the US. How US exchange rates are manipulated US can adjusts or operate its Exchange rates by selling and buying its currency on the Foreign exchange market. For instance, to increase the value or worth of a dollar, Bank of America can decide to buy dollars, whereas lowering its value would mean the bank selling the dollars. The Bank of America can influence exchange rate through its Exchange Equalization Account (E.E.A). Furthermore, exchange rates can be manipulated through the interest rates, which influence the demand and supply of US dollar through their effect on influx of hot money. In some countries or nations, their currencies depend on the exchange controls as directed by the appropriate national central bank. This implies that the central bank would only permit buying and selling of their currencies after a careful assessment of a country’s trading system, instead of depending entirely on the extent of fluctuation and variation linked with the complete floating rates. However, when it comes to US, this practice of exchange control was abandoned numerous years ago and has never been adopted in the recent past. Exchange Rates have been greatly significant to US economy based on the performance of its currency due to the fact that they represent how value of a firm escalates when a commission is levied on the exchange of one currency for another. However, exchange rates can also form a risk to those business firms that hold assets in form of currencies other than US Dollars. Furthermore, it has been influencing the US export prices, which makes a substantial component of aggregate demand, price of imports and balance of payments. Moreover, the exchange rates have a direct correlation on the US bank interest rates. For instance, the monetary Policy Committee of the Bank of America would often take into consideration the concept of exchange rate when forming short-term interest rates, thus variation in the exchange rate have another transmission entrance into the US economy, through its effect on the bank’s interest rates. Effects of reduction in the value of US dollar In a case where the economy of a nation has an output gap, a reduction in strength of US dollar will lessen export prices and when the demand is elastic, the export revenue will be raised and similarly there will be an increase of import prices especially if the demand elasticity is greater than one as well as a decrease in import expenditure. The overall effect of the value of US dollar is generally explained by its concept of the balance of payment. It is also essential to understand that the key merit of manipulating exchange is that it has a wider share of US output traded globally and these variations of the exchange rates will have an imperative effect on collective demand. For instance, lowering US exchange rate that is sometimes referred to as devaluation, would raise aggregate demand, enhance national output (Gross Domestic Product) and presuming the that the demand for both export and imports are prize sensitive, US lowering its exchange rates may result to perfection of balance of payments, although this can sometimes result to inflation just like the present situation and in the recent past, where as a result of the fluctuating exchange rate, the resultant US exchange rate has not been favoring its balance of payment thereby causing a substantial inflation pressure on its economy. According to the theory of balance of payment, International Transaction which have been one of the powerful tools for measuring the performance of US Dollar against other countries’ currency between the years 2008-2010 explains that International Transactions work as one of the many core indicators showing the prevailing economic situation of the U.S., more so, they indicates the rate of export growth which largely exhibits the demand for U.S goods and services abroad as well as the rate of imports growth which majorly explains the extent for U.S demand for foreign goods. In addition, International transactions accounts has always been taken as analytical parts of macroeconomics projecting models given that they have widely used for recording the transactions that occur between U.S and other countries over a given period of time, usually on quarterly mode. Exchange Rates vary from one country to another, depending on the rules and regulations governing that country but more essentially, different exchange rate can also affect the performance of domestic revenue that are based on the imported goods. In essence, exchange rate can be explained as the ratio of the value of money or currency for one country like in this case, the United States compared to that of other countries say U.K. It also vital to note that currencies are being continually traded on the foreign exchange markets with the prizes ever varying depending on the supply and demand of a given currency (Marazzi, Mario & Nathan Sheets 2007). In ideal situation, the exchange rate movements and fluctuations essentially symbolize the real economic basics, as explained by both long-term aspects such as structural variations based on the productivity of performance, and medium term variations explained by the economic cycles. Presently, exchange rates of American Currency have been providing signals to most firms and producers within the United States as well as serving as a buffer to short-term inflation pressures. However, sometimes the American Exchange rates just like the share prices vary more than the economic basic features. In addition, of late, the American exchange rates are a little more fluctuating and dynamic, partially owing to the fact that their economic underlying factors are more variable compared to those of bigger and less commodity dependent nations. Therefore, when it comes to exchange Rate, US live in an imperfect state that is less ideal and can be detrimental to its overall economy (Heim, 2007). Presently this essential issue in international finance has been helping in illustrating the behavior and trend of exchange rates among the three giant currencies, particularly over the last two years. The U.S dollar has weakened against most of these major currencies such that its value cannot be compared to certain currencies such as the Yen, British pound and the Euro. In fact, the behavior of the U.S dollar when compared to these other major currencies looking at the recent exchange rates are actually puzzling, to the concern of the market analysts, renowned world economists and policy makers alike, given that the US dollar has fallen consistently even when these experts projected the gaining of the currency in terms of death. A major question remains how to harmonize the large and ever growing current account deficit of the United States with the insistent waning of the US dollar. A key phenomenon of the giants’ currency markets over the last three years has been the outstanding weakness of the US dollar, particularly against both the euro and sterling pound. As discussed by many economists, the insistent diminishing strength US Currency seems to have challenging traditional justification of determining the exchange rate, based on interest rate variances and external current account inequalities. For example, over the past three years, 2008 to 2011, interest rate fluctuations have moved to favor the value of US dollar in many incidences. However, the continual boost of short-term rates from the Central Banks has been often linked with the irritating dollar feebleness. Moreover, the US dollar continues to wan in its strength in spite of mobility in the relative current accounts. For instance, the mobility of euro current account has resulted into surplus unlike the US current accounts, which has continued to record deficits. Between 2003 and 2008 the rate at which the dollar was dwindling was alarmingly high as a result of the speculators arguing that the US economy would be adversely affected owing to the implication of its financial role in the entire economic performance. This could also be explained by the global economic crisis as justified by Marazzi, Mario & Nathan Sheets (2007). Similarly, recently there has been a continuous decline in US exchange rate which has consequently has been reducing the amount of foreign currency a dollar can afford especially when it comes to import prices. Notably, such a reduction took place during the 200-2008 period, forcing the Americans to purchase foreign goods more costly and subsequently reducing the American actual incomes. These effects on American income have also been lessening US demand for the imported and domestic goods. Moreover, when imported goods are costly to Americans, the demand may tend to shift to cheaper American goods and when the dollar is cheaper compared to other currency, the US goods will tend to be cheaper thereby encouraging American exports. The correspondence that exists between the US exchange rate and prices of the imported goods is indispensible given that it helps in comprehending the US importation trend as well as the characteristics of the US consumer prices. For instance, in the recent past, given that the performance of the dollar and its strength has been diminishing, the global competition against the US producers has been greatly intensified. Nonetheless, economists have generally discovered that there is no direct relationship between costs of imports and variations in the exchange rates. For instance, between 2002 to 2008, the value of the dollar and its performance in the world market enfeebled by almost 37% as compared to a wide indices such as the price index of B.L.S (Bureau of Labor Statistics), and the U.S Unit of Labor which increased by 20%, whereas the CPI (Consumer Price Index) of imported goods rose by a mere 6%. Insufficient strong historical correlation between the imported prices of commodities and the dollar is often given as a factor influencing wide measures of key inflation. Hellerstein, Daly, and Marsh, (2006) explains that markup rates are particularly dependent on the industry and also rely on the demand curves subjected to the exporter from a specific country. Exporters experiencing an exceedingly elastic demand curves and completion might lessen their markups incase the importer currency depreciates with a view of maintaining the importer prices fixed and also preserving market share. Meanwhile, an exporter experiencing less competitors and inelastic demand might pass through the exchange rate to keep his profit magnitude which in this case, is mark-up over cost. The exchange rate-pass-through therefore relies on the structure of demand and competitiveness of the industry. The Exchange-Rate Pass-Through Based on the standard economic theory, and holding other factors constants such as the cost of border and transport, the dollar price of the American imports is equivalent to the export prices of foreign currency when transformed into dollars. This implies that E= $/foreign currency for any sales made in the US market as shown as Ptm = EtPxt, where Ptm shows the importing country domestic price, Et is the normal exchange rate, Pxt is the price of the foreign currency as expressed in units of the foreign currency. As depicted in the above equation, depreciation or weakening of the dollar, which is shown by an increase of exchange rate Et must lead to a rice in US import prices of the equivalent size. The effects of the an exchange rate on the prices of the imported products and services is normally described as the percentage change in the domestic currency of the import price Ptm. Based on these arguments, given that US currency have been waning in the recent past years, it can therefore, be concluded that its currency have been importing products and services expensively to proportional amount of the export price. Hence, the concept of exchange rate pass-through explains the extent at which the mobility of exchange rate is passed through into goods price as compared to the way they are absorbed in the producer mark-ups or profit margins (Chipello, 2004). The function of the exchange rate variations in getting rid of international trade inequalities proposed that we should expect the currency of the countries with current trade surpluses to be appreciating, while those with trade deficits to record a depreciating currency. Such kind of exchange rate would result into variations of the international comparative prices, which would work to remove or solve the cases of trade imbalances. For example, despite that all consumers saw the cost of oil escalating during the year 2009, the waning of the US dollar with respect to major trade currencies from its place by the end of 2008 offset to a certain level the increase in dollar-dependent oil prices. The dwindling of the US Dollar compared to the euro or sterling pound in 2009 implies that buyers in the US similarly experienced some constraints during the next half of the year as depicted in the figure 21 below. Considering the December 2008 exchange rate as a case study, buyers paying in both sterling and euros realized their effective year-end prices was 15 percent lower compared to those that were paying in dollars. This trend is a common feature in US balance of trade since its first occurrence in 2008. In fact hitherto, only consumers using European currencies that benefit from the ever dwindling of the U.S dollar. Furthermore, the US currencies have been falling against majority of Asian currencies particularly since the beginning of the year 2009. For instance, US Dollar has been weakening significantly against the Asian countries like the South Korean and to a lesser level against Indian Rupee. By the end of 2011, the American dollar had fallen to 14 percent against the Won compared to the average December 2008 exchange rate. On the other hand, the depreciation of the US dollar against other Asian currencies has been notably meek though. Over similar period, the falling of the US dollar against the Rupee, Chinese Yuan and Japanese Yen were 4 percent, 0.5 percent and 1.5% respectively. Source: (Sanger, 2005). There are dual strands of macroeconomic theories, which relates to the idea of how exchange rate volatility has been of late influencing the macroeconomic performance of United States. The first theory assesses how the domestic economy reacts to both the foreign and domestic actual and monetary blows under varied exchange rate regimes. On the other hand, the second strand of macroeconomic underscores the issues of how American recent exchange rate volatility based on flexible exchange rate mode influences international trade (Hellerstein, Daly& Marsh, 2006). According to macroeconomic theory, suitable exchange rate mode whether flexible or fixed depends largely on the economic shocks facing the economy or a country and the level at which capital is internationally mobile. In case of free capital movement, an economy, which is affected largely by shocks to the LM curve, as a result of the variations of the monetary demand for instance, will undergo a wide fluctuation in output, inflation and exchange rate particularly if the exchange rate is under flexible regime (Chipello, 2004). Recently, US economy has been experiencing periodic economic shocks which have, largely affected its capital movement or mobility and as consequent, their currencies have continued to dwindle causing an overall adverse effect the America’s economy. On the other hand, if the mode of exchange rate mode is that of a fixed regime and capital is also enjoying universal mobility, then the money or currency is said to be indigenous. According to Sanger (2005) variations in the currency demanded define changes and dynamism in the money supply to inhibit any consequence of LM shocks to the country’s output. A foreign actual economic shock will largely affect the local economy if only the exchange rate is fixed type. For instance, as a consequence of the recent global economic crisis, US have experienced a decline in foreign income, leading to a decrease in domestic export with a subsequent decline in domestic income. In flexible exchange rate, this impact would be mitigated via a drop of US exchange rate. Generally, the effect of the exchange rate on US instability is contingent of the type of shocks hitting the local or domestic economy, with the overall principle that dictates a flexible regime of exchange rate offers better insulation or mitigation against foreign generated real economic shocks, while fixed exchange rates protect an economy against domestic generated LM form of shock. Sanger (2005) further argues that in the present global market, the supply and demand for foreign currencies and the resultant relative strengths of the currencies in terms of their values can influence the demand for US exports and imports. For instance, a case where the US dollar is stronger and valuable compared to other foreign currencies, other currencies therefore, appears less expensive and this is can make US to obtain the imports cheaply increasing the quantity demanded. However, analysis done on the recent past shows that what is taking place is typically the opposite. Instead, the loosing of the dollar strength against other foreign currencies has made America to lessen its amount of imports of products and services given that these products appear costly for the nation (Hellerstein, Daly& Marsh, 2006). A significant negative impact of the strong dollar nonetheless, has also been experienced by the American exporters. For instance, a case where the America has a stronger dollar compared to other countries, buyers from these foreign countries view the American currency as expensive and consequently must spend more of their currency to acquire any commodity or services from the US. Hence, the magnitude of the demand for their exports would normally be lowered under these circumstances. This implies that the exporters from this region would be adversely affected particularly those that specializes in computer and Microsoft production, auto manufacturers and farmers given that they would be forced to lower their prizes to attract more customers for their products culminating into lower profit margin and at worst scenario, force out some business firms out of the business. The resultant effect of a valuable or strong dollar is a trade deficit or gap whereby there is an increase in imports and a decline in market for exports. The most striking thing about the exchange rate variation is that they can be self-adjusting and correcting over a given duration. For example, in cases of stronger US dollar, the US would demand more pesos to acquire more Mexican products and services and the idea of demanding more pesos causes the value of the pesos to appreciate, thereby making the Mexican imports to more and more costly over a given period of time. Simultaneously, the availability of US dollars in the global market would be increased, making the value of pesos to fall as the US dollar depreciates. Sometimes the US imports are less attractive but the demand for their exports have grown in the foreign countries and owing to the stronger currency of these countries, the US dollar would weaken explaining a situation in which the value of the US dollar is not valuable when compared to other currencies. Such condition helps the US exporters but adversely affect the importers. This scenario where there is a rise export but fall in the amount of imports is what result to trade surplus. However, over a time, the situation can inverse itself as the improved demand for US exports pushes up the prices of American goods globally and so, the amount of demanded foreign countries similarly begins to decreased (Hellerstein, Daly& Marsh, 2006). Conclusion In effort to Consider the extent at which the concept of exchange rates explain the performance of the US$ in recent years, the demand and supply for the currencies has been fluctuating over the past years and as these variations takes place, the values of these currencies has similarly been fluctuating. There are times when the U.S dollar has been growing strong thereby encouraging the amount of imports as goods and services from other countries become less expensive, resulting to increase in demand for the imported goods and the currency required to obtain them. Furthermore, interest rates of other countries have been growing as those of US dwindle. This has sometimes caused a rise in demand for the foreign currencies as people would tent to purchase the currency to venture in other countries securities. On the other hand, a stronger dollar against other countries’ currencies would tend to decrease the magnitude or rate of exports given that they would appear more costly to foreign customers. Hence a trade gap exists as an outcome of a stronger US dollar and the inverse impacts comes as a result of a weak U.S dollar. Summarily, when importers prefer a stronger US dollar to weaker dollar, the exporters would prefer a weaker dollar to stronger dollar. The variations of the currencies’ values influence largely the ability of the US to import or export its products and services and these uncertainties and dynamism affects greatly the standard of living of its citizens. Hence, the impacts of currency crunches in different countries of the world are not only affecting the nations in questions but also the overall global economy and standard of living. References Chipello, C. 2004. Dollar Slide Leaves Global Impact. The Wall Street Journal. Wednesday, December 29. Hellerstein, R., Daly, D. and Marsh, C. 2006. “Have U.S. Import Prices Become Less Responsive to Changes in the Dollar?” Current Issues in Economics and Finance, Federal Reserve Bank of New York, Vol.12, No. 6, 1-6 Heim, J. J. 2007 “Does A Strong Dollar Increase Demand for Both Domestic and Imported Goods?” Journal of International Business and Economics. Gale Group/Thomson Publishing 7(3), 12-22. Sanger, D. 2005. U.S. Faces More Tension Abroad as Dollar Slides. The New York Times, January 25. Marazzi, Mario and Nathan Sheets (2007):. “Declining Exchange Rate Pass-through to U.S. Import Prices: The Potential Role of Global Factors,” Journal of International Money andFinance, 26 924-47. Read More