Exchange Rates And Their Effect On Trade

Essay, Research Paper

Exchange Rates and Their Affect on Trade

I. INTRODUCTION

Objective

The general objectives of this study are to describe recent trade problems and examine

why these problems are related to, and affected by exchange rates. The study first

examines the exchange rate and how it is determined. The study will explore, in detail,

the agencies that determine these rates. This study will also present the pros and cons of

different prices of goods and services in different countries. Specifically, this paper:

(1) defines recent trade problems and how they are affected by the exchange rate;

(2) describes the steps taken within the agencies that determine the exchange

rates;

(3) examines the impact of these rates, both good and bad;

(4) analyzes the costs of similar goods in the U.S. and in foreign markets;

(5) discusses the pros and cons of the exchange rate and how it affects trade;

(6) examines various exchange rate systems: floating, fixed, and dirty floating.

Limitations of the Study

The topics of exchange rate and trade both have a variety of factors that cause changes.

As with any study that attempts to explore current developments in the economy, it is

hard to keep information current. It is also virtually impossible to report on the status of

every single government that is involved in the exchange market. One of the limitations

of this study is to report on up-to-date values of currency while choosing a sample of

governments that accurately represent the world economy. Therefore, the solution was to

use stastical figures from magazine articles and books that were written within the

previous year. Also, the countries that were chosen to be studied are considered to play

a significant role in the exchange rate market.

Plan of the Paper

This study first examines the relationship between the exchange rate and trade. This

examination includes a definition of the exchange rate, an explanation of how the rate is

determined, and a detailed description of the agencies involved in determining the

exchange rate, including the United States Treasury and the Federal Reserve Bank (the

Fed). The next section defines and evaluates three different exchange rate systems – the

fixed, the floating and the dirty floating. The third section defines trade problems, how

they are affected by the exchange rate, and also how trade is affected by the exchange

rate. Finally, this study analyzes foreign cost in terms of the costs of similar goods in

foreign markets and how similar costs are possible.

II. FOREIGN EXCHANGE RATE

Definition of the Exchange Rate

The foreign exchange rate is the price relationship between the currencies of two

countries. How the exchange rate is determined, the agencies involved in determing the

rate, and different exchange rate systems are outlined throughout this paper.

Determining the Exchange Rate

The exchange rate is determined by the supply and demand of services traded between

countries. Various agencies monitor the rate and intervene when needed, in order to

counter disorderly market conditions. Intervention involves buying dollars and selling

foreign currency, coming from th Exchange Stabilization Fund (ESF) of the Treasury, to

support the dollar?s price against another currency. Conversely, the Fed will sell dollars

and buy foreign currency to increase the strength of the dollar. The United States

Department of Treasury, the Federal Reserve, and central banks are the primary agencies

that become involved if intervention is needed.1 Although the U.S Treasury has been

assigned primary resonsiblity for internation financial policy by Congress, the Treasury

usually works alongside the Federal Reserve System when deciding to intervene. These

interventions do not occur often. Rather, they are implemented as an attempt to shift

supply and demand on a long-term basis.

Agencies Involved in Determining the Exchange Rate

The Federal Reserve Bank and the United States Department of Treasury are primarily

resonsible for keeping records on the Balance of Payments, which relates directly to the

determination of the exchange rate. These agencies are responsible for keeping track of

the flow of money that is used to purchase merchandise, securities, and services, as well

as payments made to other countries by the United States.

In addition, these agencies are responsible for determining when to intervene in the

exchange rate.

Balance of Payments and the Exchange Rate

The most important factor in determining the exchange rate is the Balance of Payments,

which is an accounting record of all international transactions for a particular country

during a specified time period. The Balance of Payments is figured using two primary

accounts: the current account and the capital account. The current account is further

subdivided into four accounts: Merchandise Trade, Services, Income Receipts, and

Unilateral Transfers. The Capital Account is also further divided into four accounts:

Direct Foreign Investment, Portfolio Investment, Bank Related Flows, and Official

Reserve Transactions. In theory, the current account and the capital account should

balance and the sum of the balance of payments should be zero. However, due to

statistical discrepancies, accounting conventions, and exchange rate movements that

change the recorded value of transactions, the balance is typically a deficit or surplus.

Some of the factors that can affect the Balance of Payments occur when, for example, the

United States buys more goods and services than it sells, and must finance the difference

by borrowing, or selling more capital assets than it buys.

Any transaction that causes money to flow in or out of a country is included in the

Balance of Payments. Because the exchange rate is determined by the supply and

demand of a country?s currency, it is directly related to the Balance of Payments.

To help clarify the format for which the Balance of payments is determined, the 1993

U.S. Balance of Payments statement is included on the next page.

III. EXCHANGE RATE SYSTEMS

Fixed Exchange Rate

In 1944, a group of representatives from throughout major industrialized countries, met

in Bretton Woods, New Hampshire and established the fixed rate exchange system,

known as the Bretton Woods Account. This system was developed as an entirely new

international financial system as an attempt to curb fluctuations in currency values. The

exchange rates were fixed using the U.S. dollar as the official reserve currency, and a

country?s central bank had to buy or sell supplies of its currency using dollars, in the

event that the exchange rate strayed from the pre-determined rate. 2

Floating Exchange Rate

The Bretton Woods fixed exchange system stayed in effect until the early 1970?s, when it

collapsed and was replaced with the floating exchange rate. This system did not impose

a pre-determined exchange rate. Instead, the exchange rate is allowed to change and

fluctuate as individuals, businesses, banks, and governments buy and sell the currencies

of other countries. This creates a rate that is constantly changing – not only by the day or

by the hour, but by the minute.

Dirty Floating Exchange Rate

The floating exchange rate can be further divided into two forms: clean or dirty floating.

Clean floating refers to a rate in which the central bank does not intervene to affect the

exchange rate. Dirty floating, which is more commonly practiced than clean floating,

involves intervention from the central bank to influence the exchange rate. One of the

advantates of a floating exchange rate is that although an internal crisis is possible, there

will never be a foreign exchange crises.3

IV. TRADE PROBLEMS

Definition of Trade Problems

As mentioned earlier, when the Bretton Woods system failed, the United States

established a floating exchange rate, although many economists feared that a floating

rate would be harmful to the operation of international trade. A floating rate was viewed

as highly unstable and it was thought that the indirect effects of this instability would

limit stimulation of trade. Without stability in trade, the supply and demand required to

keep the rate at equilibrium would be disrupted and create an exchange crisis.

Trade Problems as a Result of the Exchange Rate

The exchange rate creates a problem in trade when a currency becomes overvalued,

either as a result of the inflation rate remaining higher than that of its trading partner, or

because the currency to which it is adjusted is rising and dragging the lower currency up.

This overvalue leads to poor comptetitiveness – resulting in a loss of trade. In 1998,

United States exports declined in almost all product groups, including agricultural items,

industrial materials, capital goods, and even exports of services. To compound this

problem, the U.S. experienced an increase in the number of imports. These two factors

are crucial when explaining the U.S. trade deficit; however, the shifting of exchange rates

has also played a part in the erosion of the United States competitivness in the global

economy.

In light of these problems, the dollar still remains strong. Trade problems are not only a

result of situations in the United States, but as a result of the stability (or instability) of

the exchange rate in other countries as well. A floating exchange rate works well in the

U.S. because of the strength of the dollar. However, some countries have attempted to

use an ?adjustable peg? system, in which their currency is adjusted to that of a larger

economy, with the option to adjust when underlying conditions change. This system has

not proven to be beneficial, as in the cases of Brazil and Russia in 1998-99. Both of these

countries experienced exchange-rate overvaluations and were forced to abandon their

current exchange system. 4 This trend can be seen in the chart below. The economic

crisis in Russia began to unfold in August of 1998, at the same time that the Ruble was

decreasing in value. As the Ruble became increasingly overvalued, the Russian economy

experienced more strain. This kind of economic crisis leads to an increase in imports

from these countries and a decrease in exports.

Source: 1999 Country Report on Economic Policy and Trade Practices

Exchange Rates and Their Affect on Trade

The exchange rate is one of the leading factors when countries decide what products and

services to import and what products and services to export. While it is not the only

factor that is considered, the exchange rate affects the ratio of the prices and allows

countries to decide whether it would be profitable or not to import or export certain

goods. For example, if the United States was considering trade with the U.K., four

factors would be considered when determining which products would be imported and

which products would be exported: 1) the price of the goods in U.S. dollars, 2) the price

of the goods in U.K. pounds, 3) the U.K. price in dollars at the exchange rate, and 4) the

ratio of the U.S. price to the U.K. price. The following chart illustrates the hypothetical

cost to sell soybeans, gloves, and stereos in the U.S. compared to the U.K. Using the

current exchange rate converts the cost of the goods into a common denominator, and

allows each respective country to figure price differentials that are in their favor. It is

assumed that there is a competitive market.

Price and Cost Differences

As this chart shows, when comparing soybeans and gloves, the price of gloves in the U.S.

are half the price of gloves in the U.K. The price of soybeans is similar. The price of

stereos, however, are in favor of the U.K., since the cost 300 dollars in the U.S. and

would cost 180 dollars in the U.K. As a result of these differences, the U.S. would be

more likely to export gloves and soybeans, and to import stereos from the U.K.5

If the exchange rate were to change, the prices of goods in dollars would also change,

possibly creating change in the desire for countries to import or export certain goods. For

example, if the exchange rate between the U.S. and the U.K. grew to $10 per pound, than

the cost of goods in the U.K. would become very expensive, and the U.S. would want to

export all goods to the U.K.

One of the problems in trading that can occur as a result of the exchange rate is the

option to create monetary barriers. These barriers are typically used by countries to

eliminate trade or control the amount of imports. There are three types of monetary

barriers that are typically used to controll the exchange rate:

1) Blocked Currency

Countries that wish to eliminate imports restrict the availability of foreign

exchange. Governments in each country can decide to block currency from

various classes of foreign creditors. These countries designate certain currency for special

use, not for free universal use, and currency that is blocked is cheaper than currency that

is unrestricted. The discounted rates also applied to foreign exchange. For example,

Germany designated a number of special types of blocked marks which were only to be

used as government officials designated. These marks were cheaper than free marks,

which created a block on the number of marks exchanged.

2) Differential Exchange Rates

Countries who use this method set different rates for converting currencies into

foreign monies in order to control the amount of import goods from a given

country, usually in an attempt to control the flow of a particular commodity. 6

3) Higher Conversion Rates.

This method, which is rarely used due to the bad publicity it recieves and the

strain that it puts on government relations, is used to set high conversion rates

to stop the flow of imports.

V. DIFFERENT EXCHANGE RATE SYSTEMS

Analyzing the Cost of Similar Goods in Foreign Markets

There are quite a few variables that can be analyzed when looking at the cost of goods in

foreign markets. Not only does the exchange rate vary the costs of trade, but very

country has different tariffs, trade sanctions, and barriers that they choose to impose on

their import and export markets. For example, the import and export market in

agriculture between Japan and the U.S., and China and the U.S. has undergone numerous

changes in the past few years, including the import of rice. China, which describes its

exchange system as a managed float, continues to impose barriers on the importing of

U.S. good and services. In 1996, China announced a new tariff that would apply to

agricultural items, such as rice. However, as of late 1998, they had still not announced

the specifics of this tax, which complicates trade in these goods.

Japan has also imposed tariffs and barriers to restrict trade. While it has reduced many of

its formal tariffs, Japan still maintains control by imposing nontariff barriers, such as

discriminatory standards. Japan has also begun to import rice into it?s country.

However, rather than introducing the rice to the country?s consumers, the rice is

stockpiled for food aid to third world countries.

VI. CONCLUSION

The exchange rate is one of the primary factors in the business of international trading.

While there have been system changes in the United States, from the Bretton Woods to

the present floating rate; and there are differing systems that are implemented

throughtout the world, the fact remains that the exchange rate is the basis for an amazing

amount of financial decisions – including trade. Economists will argue over which

system is best, but there is not doubt that whatever system is chosen will still have to be

able to withstand the constant fluctuations in supply and demand. In the past few years,

the world has seen supposed stable markets plummet after an overvaluation of their

currency. Brazil and Russia are just a few of the countries that were affected – Mexico,

Asia,Thailand, Malaysia, the Philippines, and Indonesia are other countries who have had

to overhaul their exchange system. Right now the dollar remains strong. However, the

plight of these countries not only creates an internal crisis, but it creates a small amount

of panic throughout the world.

Bibliography

Contained in footnotes above