Countries around have got distinct currencies that citizens use for local daily transactions. However, when it comes to the international transactions or trade, one needs exchange the local currency with the corresponding international currency to facilitate transactions. The currency exchange rates show how much one unit of a given currency can be exchanged for another international currency. In the financial market, it is evident that different currencies have got different values. But the question that best explains why currencies have different value is the question of “how currency exchange rates are determined in markets.” Three main types of exchange rate regimes best explain how currency exchange rates are determined in markets. These are flexible rates; fixed-rate, unified currency; and, pegged exchange rates. The above three types of exchange rate regimes are what is referred to as the determinants of the exchange rate.
The flexible rates are brought about by the forces of demand and supply. Here the level of demand in relation to supply of a given currency will determine the value of that particular currency in relation to another one. For instance, if Europeans increase their demand for U.S. dollars, then the supply-demand relationship results in an increase in price of the U.S. dollar relative to the Euro. In this case the value of the U.S. dollar increases in relation to the Euro as illustrated in the figure below.
In a fixed rate regime, certain currencies are linked to a common currency at a fixed rate. An example of a fixed rate regime is the ones that involve the 18 European countries under the European monetary union where all the member countries use a unified euro currency. The same fixed rate regime is used by the U.S., Hong Kong, El Salvador, Ecuador and Panama where they are unified by a common U.S. dollar. The countries that agree to link their currencies to a unified currency accept the monetary policy of the unifying currency. For instance, all the 18 countries using the euro accept the monetary policy of the European Central Bank while those such as Hong Kong and Panama accept and use the monetary policy of the U.S. Federal Reserve. In a pegged exchange rate regime, countries involved chose to using monetary & fiscal policy to preserve the exchange-rate value of the domestic currency in relation to foreign currencies.
Balance of Trade and Exchange Rate
Balance of trade is the difference brought about by a nation’s export and imports with the transactions recorded in a balance of payment account. A balance of payment account records a country’s exports in credit items whereas the imports are recorded in debit items. The balance of trade has an effect on currency exchange rates through its effect on the demand and supply for foreign exchange. Sometimes the balance of trade coincides with its exchange rate with another country. For instance, when a country’s trade account does not net to zero, when imports exceeds exports then there is relatively more supply for that country’s currency. For instance, if South Africa imports more from the U.S. than it exports, there will be an increase in the supply of the South African currency in exchange rate market resulting in the depreciation of the rand in relation to the dollar.