# Exchange rate

Exchange rate of the euro to the US dollar since the euro was founded

The exchange rate is the price of one currency expressed in another currency. The market on which this price is formed is the currency market .

The exchange rate is very important for the economy as it influences, for example, the international competitiveness of a currency area (see exchange rate mechanism ). Changes in the exchange rate pose a risk ( exchange rate uncertainty ) for companies and investors if claims are linked to a foreign currency .

## Types of exchange rates

In general, exchange rates are differentiated according to two criteria:

### Nominal exchange rate

Basically, the nominal exchange rate indicates the ratio in which the currency of one country can be exchanged for the currency of another country. The nominal exchange rate can be expressed in terms of quantity or price. The quantity quotation ( indirect quotation ), exchange rate in the narrower sense, indicates the price of a unit of the domestic currency in units of the foreign currency (using the example of Europe and the USA from a European perspective: dollar per euro). In contrast, the price quotation ( direct quotation ) or the "exchange rate" indicates the price of a unit of the foreign currency in units of the domestic currency (euro per dollar from a European perspective). The price quotation is thus by definition the reciprocal of the volume quotation.

In the eurozone, Great Britain, Australia and New Zealand, the bulk quotation is used today, while otherwise the price quotation is common, especially in Switzerland. In the euro zone , the price quoted was common up to the euro launch.

The exchange rate in volume quotation is through ${\ displaystyle e _ {\ mathrm {M}}}$

${\ displaystyle e _ {\ mathrm {M}} = {\ frac {\ text {units of foreign currency}} {\ text {one unit of domestic currency}}}}$

calculated, in price quotation (exchange rate) it is

${\ displaystyle e _ {\ mathrm {P}} = {\ frac {\ text {units of domestic currency}} {\ text {one unit of foreign currency}}} = e _ {\ mathrm {M}} ^ {- 1}. }$

### Real exchange rate

The real exchange rate describes the ratio at which a representative basket of goods in one country can be exchanged for a representative basket of goods in another country. The real exchange rate is thus defined as an index, so its absolute value has no informative value. Only by looking at the rates of change over time can important insights be gained. The rate of change shows the development of a country's purchasing power.

A currency that appreciates in real terms is characterized by higher purchasing power compared to other countries (one also speaks of improved terms of trade ), but at the same time it reduces the competitiveness of the domestic economy.

### Exchange rate at financial institutions

Since the administration and billing in the currency business is not only labor-intensive, but the financial institution takes a risk when buying foreign currency, varieties are usually sold at the low bid rate and the higher ask rate . These rates differ to a greater or lesser extent from the exchange rates that are used, for example, for transfers abroad. In some countries with high exchange rate volatility , hard currency is preferred, so it can be more advantageous for travelers to first exchange money in the destination country.

### Bilateral and effective exchange rates

The bilateral exchange rate is when the exchange rate refers to two currencies. If, on the other hand, one looks at the exchange rate between a currency and a currency basket , one speaks of the effective (or multilateral) exchange rate.

The currency basket is formed from the currencies of the most important trading partners. The effective exchange rate is determined by taking the average of all bilateral exchange rates in the currency basket, with each bilateral exchange rate being weighted with the share of the respective country in foreign trade . If weighting is carried out with the export share, then one speaks of the export exchange rate , if, on the other hand, weighted with the import share , then one speaks of the import exchange rate . Most of the time, the average is formed from the export and import share, in this case the effective exchange rate is called the external value of the currency.

The effective exchange rate is important because, from a company perspective, exchange rates a. are important indicators of one's own competitiveness. However, by definition, an exchange rate can only ever compare two economies with one another. This reduces its informative value. In order to arrive at a more fundamental understanding of a country's competitiveness , all other exchange rates that are important for exports and imports would have to be taken into account - this is achieved by the effective exchange rate.

The European Central Bank (ECB) calculates the effective external value of the euro against the currencies of 23 main trading partners (the so-called EER-23 group ). However, v. a. the US dollar, the British pound and the Japanese yen, which currently together account for more than 55 percent of the total effective exchange rate of the euro. Although the currencies that do not belong to the EER-23 group play a relatively unimportant role, the ECB also determines the effective exchange rate for the 42 most important trading partners, the so-called EER-42 group .

## Exchange rate theories

There are several theories for the theoretical justification of exchange rate fluctuations, which establish a connection between the exchange rate on the one hand and the price level , income or interest rate at home and abroad on the other. These theories are usually partial analytical , that is, they consider the change in one (or less) variable that determines the exchange rate.

Basically, one can differentiate between two types of approaches:

1. Electricity approaches: They target the effect of the change in price level, income or interest rate on the capital account and the current account . This direction includes:
• Mundell-Fleming model (absorption approach): Based on a Keynesian theory, this approach is based on the current account balance (LBS) of a country in order to predict future exchange rate developments of the respective currency.
• Interest parity approach : "Money goes where the highest returns can be achieved." If international capital markets are free of capital controls and domestic and foreign financial stocks are perfect substitutes, then the use of arbitrage opportunities leads to a perfect match of the corresponding rates of return in Germany and abroad Abroad, resulting on the one hand from the direct interest income with regard to the domestic and foreign interest level and on the other hand from changes in exchange rates. Any deviation in the rate of return will lead to capital movements that are geared towards the exploitation of profit opportunities and will continue and lead to adjustments until a new adjustment is made.
• Parities approach: The purchasing power parity passes the exchange rate between two currencies from the relation of the respective price levels from. It says that exchange rates fluctuate mainly to compensate for differences in price levels between currency areas. Goods baskets that only contain internationally tradable goods are relevant. This approach is based on the principle of the “law of one price”. According to the purchasing power parity theory, a monetary unit must have the same purchasing power in all countries, i.e. it must have the same real value everywhere.
2. Inventory approaches: They aim at the effects of changes in assets (portfolio approaches). This includes:
• monetary approach
• Financial market approach (asset approach)
• macroeconomic portfolio theory

## Changes in exchange rates

In principle, changes in exchange rates result from the supply and demand behavior of market players. The exchange rate occurs where supply and demand for a currency meet. Both large investors (e.g. central banks of all countries, major international banks and companies) and small investors appear as market players.

While in systems of flexible exchange rates the exchange rate changes only arise through supply and demand behavior of the private market actors, in systems of fixed exchange rates the respective central bank acts as an additional market actor who buys or sells its currency (so-called foreign exchange market intervention ) until the fixed exchange rate is reached.

Changes in exchange rates are of great macroeconomic importance and therefore also play an important role in economic policy . Looking at the changes in exchange rates over time, it can be concluded how the market players assess the development of an economy.

Since the exchange rate forms on a very liquid and often volatile market, experience shows that exchange rates fluctuate very strongly in systems of flexible exchange rates. The measure of the fluctuation intensity of an exchange rate is called exchange rate volatility . Large changes in exchange rates usually occur in the context of general financial or economic crises .

### Revaluations and devaluations

A currency appreciates when its price rises in the foreign exchange market ; devaluation occurs when its price falls in the currency market.

A distinction is made between nominal and real exchange rate changes:

• A nominal appreciation or depreciation occurs with every change in the nominal exchange rate .
• Real appreciation or depreciation, however, requires a change in the real exchange rate.

### Mathematical representation

Formally, the percentage change in the exchange rate (WK) can be calculated as follows:

${\ displaystyle {\ text {Rate of change}} = {\ frac {WK_ {t} -WK_ {t-1}} {WK_ {t-1}}} = {\ frac {WK_ {t}} {WK_ {t -1}}} - 1}$

If the exchange rate is represented in volume quotations, positive rates of change mean an appreciation of the domestic currency , while negative rates of change mean a devaluation (devaluation). The opposite is true, if the exchange rate is shown in price quotation (foreign exchange rate), then positive rates of change correspond to a devaluation and negative rates to an appreciation of the domestic currency.

Example: If the euro appreciates against the US dollar, the exchange rate in the usual quantity quotation ( indirect quotation ) rises from 1.25 USD / EUR to 1.50 USD / EUR, then the rate of change is 0.2 corresponds to an appreciation of twenty percent.

### Triggers changes in exchange rates

If the reasons for the excess supply and demand are known, then it is also known how the market players (or the government in the case of a fixed exchange rate system) assess the development of an economy. The main triggers can be:

• Changes in exchange rates triggered by private market players are often due to changes in exchange rate expectations (see also futures market ). Investors expect a currency to appreciate and buy this currency in order to benefit from the increase in value.
• An increase in a country's key interest rate increases demand for that country's government bonds . Since the bonds have to be paid in the currency of this country, there is an increased demand for this currency and an appreciation occurs. The currency depreciates accordingly when the key interest rate of the respective country falls.
• Increased investment interest by foreign investors leads to increased demand for domestic currency, which leads to an appreciation. Accordingly, a decline in investment interest leads to a devaluation.
• Changes in exchange rates can also be caused by foreign exchange market interventions by the central bank (so-called realignments ). Here the central bank buys or sells domestic for foreign currency units.

### Effects of changes in exchange rates

Changes in the exchange rate (especially with respect to important trading partners) are significant influencing factors for the overall economic development of a country and often also that of its trading partners. The effects are very diverse, they only reach their full development over a longer period of time. The main effects are:

• As a result of devaluation, residents have to pay more domestic currency for the same amount of imported goods. This results in a decrease in the amount of imports and an increase in the demand of residents for domestic goods in order to meet the demand for goods regardless of the exchange rate effect. At the same time, foreign importers need to spend less of their currency to get the same amount of goods. This leads to an increase in the export volume. As a result, the country's current account is improving . However, this also leads to a deterioration in the terms of trade , since only a small amount of imported goods can be paid for with the proceeds of a constant amount of export goods. The resulting positive effect is reflected in the increase in employment in Germany.
• The current account effect of an exchange rate change can be different in the short term than in the long term; This is referred to in the literature as the “ J-curve effect ”: Since the invoices are predominantly invoiced in the currency of the respective delivery country, imports become more expensive (expressed in domestic currency) if export revenues remain the same. This results in a deterioration in the current account. Only when the price lists are adjusted and this price change leads to demand reactions via the respective import and export elasticities, then exports rise, so that the current account improves.
• Exchange rate fluctuations have an impact on inflation development: A depreciation of the domestic currency directly causes a rise in import prices and thus the consumer price index . As a result, residents can buy less goods ( real disposable income falls) because they have to spend more money on imported goods. Conversely, an appreciation has the effect of curbing inflation, so that real disposable income increases. This effect is short-term in nature.
• In the medium term, an appreciation means a loss of competitiveness for domestic companies, since the goods exported abroad will become more expensive and exports will decline. On the other hand, a devaluation has a stimulating effect on the export economy. In the context of the balance of payments theory , the effects of exchange rate changes on foreign trade are examined. Important approaches for this are for example the Marshall-Lerner condition , the Robinson condition or the J-curve effect.
• If the currency of a country devalues ​​so that the competitiveness of this country improves, then this means for other countries that their competitiveness decreases. This economic policy, which aims to increase competitiveness by devaluing the currency at the expense of other countries, is called competitive devaluation or, more generally, beggar-thy-neighbor policy (in German: beggar your neighbor).

## Exchange rate regime

In principle, the price can either form freely (flexible exchange rate) or be set by a central bank (fixed exchange rate). There are also numerous intermediate and special forms. As a rule, the more closely two economies are linked, the more fixed the exchange rates should be, but only if both economies have a coordinated and coherent monetary and economic policy.

Flexible exchange rates have the advantages:

• autonomous monetary policy : the central bank can freely decide on interest rate policy
• To make speculation (almost) impossible
• To (theoretically) avoid under- and over-valuation in the medium term, i.e. to enable optimal allocation
• Allow stability countries to limit the effects of imbalance in other countries, e.g. B. with imported inflation

• high volatility , which many economists believe can hardly be justified by fundamental data
• Transaction costs due to the uncertainty (such as currency hedging transactions)

Fixed exchange rates have the advantages:

• no transaction costs in the form of currency hedging
• apparent security for foreign investors
• Calculation security for import and export

• Loss of autonomy in monetary policy: The monetary policy of the central bank of the anchor currency is adopted
• Hedging costs: Direct intervention costs (foreign exchange losses) when buying and indirect (inflation) when selling your own currency
• Vulnerability to imported inflation