No Country can grow and increase productivity by itself. Certain raw material and expertise are requested to make a win-win situation for all the parties in an international transaction between two different countries. When countries deal, they need a currency exchange rate to decide the worth of their merchandise in the foreign currency and pay the required amount to the other party in the transaction. The Global corporate World is doing daily business of $5.5 Trillion. Exchange rates prove to be the deciding the rates of currency that further aids in making international business transactions. It is set by foreign exchange markets and is volatile. The decision is a mix of several variables such as the interest rates in the countries, Strength of the economy and outstanding loans. In short, Exchange rate values domestic currency regarding foreign currency. The exchange rate is an interesting concept that rules the global corporate World. United States Dollar is considered as the global currency, and all other currencies are checked for its worth against the Dollar. Exchange rate involves two currencies. The foreign currency is taken as the base currency which is Dollar in the most global market, and the domestic currency is weighed to counter the base currency. Euro is special because Dollar is weighed regarding Euro in international transactions. Euro has shown proved to be defining the exchange rate against its appreciation and depreciation over the last decade. (Lucio Sarno, 2003).
There are several variables that affect the exchange rate such as inflation differentials, Relative pricing Interest rates, Political and economic environment plays an important role in the exchange rates of different currencies in the international economy. Euro-Dollar exchange rate has high impact in the European market. Euro is worth 11.8% against the Dollar in 2016. This shows the steadiness in the Euro against the discrepancies in the exchange rate. The worth of Currency is determined by demand and supply of money in the foreign exchange market. Capital cash flows and trade debts flow affect the exchange rate. Government intervenes in managing the worth of their currency through alteration in interest rates and fiscal policies. The major factors affecting the Euro-Dollar exchange rate includes the interest rate differential between United States dollar and Interest rates in the home country. The relationship between prices of business and non-business goods and services in the countries. Another major factor that affects the exchange rate is the international oil prices and other minerals. The last but the not the least factor affecting the exchange rate of Dollar and Euro is the fiscal position of the trading countries.
There are several factors that can increase the price of Dollar against the Euro. Interest rates are one of the factors that can appreciate the Dollar against Euro. Increasing interest rates predicts a high rate of return on investment in a country thus increasing the value of its currency and increase the exchange rate. Another major variable in play is the inflation rate that affects the interest rates thus affecting the exchange rate in the long run. High-interest rate tends to increase the exchange rate of Dollar against the Euro and vice versa.
Foreign exchange rate determines the economic health of a country. The balance of payment is the monetary mix of all the transactions takes place between two trading economies over a fixed period. This shows the total amount of business transactions and allows the economist to devise policies for the long run to avoid the negative impact of trade deficits in the economy of a country. A deficit in the balance of payment states that the worth of imports is higher than the worth of exports. There is an assumption that if the current account deficit is covered with Surplus in the economy than it might have less effect on the depreciation of currency however if economy struggles to increase the capital inflows so that the deficit is maintained, face depreciation in Dollar. The United States had 7% current account deficit that played a fair role in Depreciation of Dollar at the start of financial crises (Yomba, 2009).
Euro and Dollar are the two major international currency that affects the international trade transactions. Increase in Dollar price against Euro predicts a decrease in the Euro price as the Euro appreciate and depreciate in comparison with Dollar and vice versa. It means that more dollars are required to purchase a Euro, and on the other end, it takes fewer Euros to purchase Dollars. The relationship between exchange rates of currency is a complex economic area that is influenced by many factors. Exchange rate affects the prices of goods and services in an economy as it affects the interest rates and inflation rate thus affecting the final consumer either positively or negatively.
In Macroeconomics, there are several metrics used to analyze and measure the strength of economic conditions of a country. Purchasing Power Parity is a metric used to compare the base currency and counter currency by applying the rates to a defined basket of goods. It is assumed that if inflation rates in both the trading countries remain the same than their currency are equal in worth. For understanding purpose, assume one Dollar is equal to one Euro. It means that the price of a basket of goods remain the same as the inflation rate are stable, and currency equalizes each other thus securing the investors. However, in real economic conditions, there is always change in the prices and currencies due to the multiple variables affecting the exchange rates. Purchasing power parity theory suggests that dependence of consumer of the final product to purchase the goods and services is not dependent on the currency he is dealing, it is dependent on the purchasing power of the currency in the market. The purchasing power of the currency is determined by the international market in comparison with the domestic market.
In the long-run, purchasing power parity theory determine the differential in the market rate of different currencies and tries to mitigate the effect through changes in the exchange rates. The difference in the exchange rate determines the profit value for the countries and allow them to earn the arbitrage profit. Purchasing good and services in the economy where prices are low and selling them in the country where the exchange rate is h (Yomba, 2009)high would benefit the investors. In short Purchasing power parity theory suggest that the prices of a mix of commodities need to be equal in both the markets so that the prices are equalized through the exchange rate. However the real economic scenarios are different, and the purchasing power parity theory doesn’t always work in practice (Bahmani‐Oskooee, 2013).
Import Quota is the pre-decided quantity or Worth of Defined goods and services that are imported by a country during a fiscal year. Quota place embargo on the purchase of items by a country once the quota is filled. On the other hand, Tariff is the duties and charges on the international currency or the physical quantities of goods and services. Tariff allows the purchaser to purchase goods as much required and pay the relevant excise and customs duties to pass the goods to the home country. Tariff is tools used by authorities to restrict the imports of certain goods and services into the country. A tariff is a feasible option for an economy due to the liberty it allows to the governments to controls the goods and services going out and coming in into the country. Tariff is more beneficial to an economy as compared to the Import quotas; the reason is that Tariff generates revenue and is dependent on the number of goods and services imported into the country. On the other hand, quotas once filled can’t be crossed. Import quotas are prone to corruption at the administrative level. In short, a Tariff is a preferable option and less harming due to lower risk of corruption and the control government it has on the revenue of tariff. There is economist who is of the view that import Quotas and tariff are risking the international trade and restricts it in one way or another. Economist suggests the free market economy where no restrictions are placed, and government works for maximizing the business with the international World. Tariff is feasible when there is an increase in demand for the import products. If the demand increase investors and importers have the option to import more goods to sustain the supply and demand of the product. In Import Quota, there is a restriction which will increase the prices of import goods in the domestic market due to the increase in demand and the embargo on more imports in the import quotas system.
Bahmani‐Oskooee, M. (2013). Exchange rate volatility and trade flows a review article. emeraldinsight, 12.
Lucio Sarno, M. P. (2003). The Economics of Exchange Rates. Cambridge University Press.
Yomba, S. J.-P. (2009). Micro Economics to Macro Economics: The Concept of Market Exchange Rate. AuthorHouse.