Exchange rates

An exchange rate can be defined as the price of one currency in the terms of another. It is the value of a foreign nation’s currency in terms of the home nation’s currency. For example an exchange rate of 2800 Belarusian rubles to one dollar means that 2800 Belarusian rubles are worth the same as 1 USD.

Let’s turn to the history of exchange rates. The Bretton Woods agreement of 1944 established fixed exchange rates defined in terms of gold and the US dollar. Between 1944 and 1971 many countries were pegged against the US dollar. In this period, a US dollar was a promissory note issued by the United States Treasury. But this system was abandoned in 1971 because following inflation, the Federal Reserve didn’t have enough gold to guarantee the American currency.

Gold convertibility was replaced by a system of floating exchange rates. A freely floating exchange rate is determined by supply and demand. Theoretically, in the absence of speculation, exchange rate should reflect purchasing power parity (the cost of a given selection of goods and services in different countries). Proponents of freely floating exchange rates argued that currencies would automatically establish stable exchange rates which would reflect economic realities more precisely than calculations by central bank officials. Yet they underestimated the impact of speculation.

And it’s necessary to say that today few governments leave exchange rates wholly at the mercy of market forces. Most of them attempt to influence the level of their currency when necessary. So, managed floating exchange rates are more common than freely floating ones. In 1979 most countries of Europe joined the European Monetary System with its Exchange Rate Mechanism. This established parities between member currencies and a margin of plus or minus 2.25%. If the rate diverged by more than this amount from the central parity, governments and central banks had to intervene in exchange markets, buying or selling in order to increase or decrease this amount from the central parity.

It goes without saying that any business engaged in international trade, whether in goods or services, is affected by the exchange rate. That’s why many manufacturers are in favour of fixed exchange rates, or a single currency (like euro for instance). Although it’s possible to some extend to hedge against currency fluctuation by way of futures contracts, forward planning is difficult when for instance the price for raw materials bought from abroad can rise or fall by 50% in only a few months.

And the last thing that I want to say is that exchange rates certainly influence businesses, it’s inevitable, but nevertheless they can reduce this influence and be successful!