Exchange rates are an important aspect of international business that takes place in the foreign exchange market. Fluctuations in exchange rates can be caused by movements of interest rates and inflation along with other factors. As each country has its own currency, businesses trading internationally should always be aware of exchange rates to ensure profitability.
The Idea in a Nutshell
Exchange rates first originated from the Gold Standard which started in the United States in the 1870’s. In the Gold Standard, monetary value was based on gold. Today, the Gold Standard no longer applies. Each country has a different value for their currency. An exchange rate is an important and complex concept when participating in international business because there are so many different currencies in the world. Many factors including inflation, interest rates, and economic growth affect the way exchange rates fluctuate. It is important that businesses trading internationally pay close attention to these fluctuations as it could lead to their success or failure.
The Top Ten Things You Need to Know About Exchange Rates
1. Throughout the world many different currencies exist. The foreign exchange market has two functions. The first function makes trading possible between different countries by allowing them to convert different types of money.
2. The costs of goods and services in each country will have different values because currency differences apply depending on the country in which they are sold. For example, one dollar in the United States is equivalent to fifty one cents in the United Kingdom.
3. Exchange rates are determined by the supply and demand of the currency in a particular country. The change in currencies between countries could impact the profitability of products sold. According to International Business, as the value of the Korean won increased and the United States dollar remained steady, Korean businesses were no longer making as much profit when converting the dollar back to won. As a result, Korean companies needed to increase the prices of the goods and services being sold to maintain profits.
4. The second function of the foreign exchange market is to protect both individuals and international companies against consequences such as financial losses from fluctuating exchange rates. Again, each country’s currency is valued differently from another.
5. At times, the government within a country may decrease the value of its currency as a means to increase the demand for products sold within that country. It also increases the probability of foreign companies investing in the country with the devalued currency. As a result, the country with devalued currency earns higher profits because of a higher demand for its products and an increase in investment within that country.
6. Exchange rates can determine the amount of imports and exports in a country along with economic growth. About.com: U.S. Economy explains that when monetary value is high, exports will decrease and imports will increase. This is because a country can import goods at a lower cost, but exports will have a higher cost. This can slow economic growth. When monetary value is low, a country will import less and export more. This is because other countries will choose to purchase from countries with lower currency values to save money. According to About.com, “this could strengthen the economy in the long run.”
7. Exchange rates fluctuate constantly and they are very complicated to predict. This means that activities such as currency speculation could be financially dangerous. If an international business decided to invest money in another country because they had thought the exchange rate would increase but it actually decreased, the business could lose a large sum of money.
8. Exchange rates can be predetermined for future sales between countries. This type of exchange rate is known as a forward exchange rate. Forward exchange rates happen when a country fears that the value of their currency may fall before they are paid. If the country uses a forward exchange rate, the current exchange rate will freeze for a certain amount of time, and they will be able to receive the same amount of money even if the currency value decreases.
9. Inflation can cause exchange rates between countries to fluctuate. High inflation in a country causes the monetary value to decrease whereas low inflation could cause monetary values to increase. It’s best for a country to have low inflation where the value of the currency is worth more.
10. Interest rates play an important role in the fluctuations of exchange rates. Exchange rates will rise in a particular country when interest rates are high because international businesses will be more willing to invest in a country with a higher valued currency. If interest rates were low, exchange rates will decrease.
The Video Lounge
This is a video from YouTube that explains what factors cause exchange rates to fluctuate in a simple and understandable form. The video discusses how exchange rates are related to both interest rates and inflation. It also explains how exchange rates are related to supply and demand. As a country becomes more competitive, demand will increase and exchange rates will rise which results in higher monetary value for that country.
Many factors contribute to the fluctuations of exchange rates. In my opinion, this concept is still relevant today because when doing business internationally, it is very important to understand what factors cause the value of a currency to rise or fall. International trade depends on foreign investment, imports, and exports and every business wants the best deal for less money. If managers understand this concept, they will be more knowledgeable and able to make better decisions for their company.
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Moffatt, Mike. Purchasing Power Parity: Link Between Exchange Rates and Inflation. Retrieved from https://economics.about.com/od/purchasingpowerparity
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Contact Info: To contact the author of “Top Ten Management on Exchange Rates,” please email Jason Sibley at Jason.Sibley@selu.edu.
David C. Wyld (firstname.lastname@example.org) is the Robert Maurin Professor of Management at Southeastern Louisiana University in Hammond, Louisiana. He is a management consultant, researcher/writer, and executive educator. His blog, Wyld About Business, can be viewed at https://wyld-business.blogspot.com/. He also serves as the Director of the Reverse Auction Research Center (https://reverseauctionresearch.blogspot.com/), a hub of research and news in the expanding world of competitive bidding. Dr. Wyld also maintains compilations of works he has helped his students to turn into editorially-reviewed publications at the following sites:
- Management Concepts (https://toptenmanagement.blogspot.com/)
- Book Reviews (https://wyld-about-books.blogspot.com/) and
- Travel and International Foods (https://wyld-about-food.blogspot.com/).