Exchange Rates and Their Affect on Trade
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
(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
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
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.
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.
Contained in footnotes above
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