What is an Exchange Rate?
An exchange rate is the value of one unit of a currency in terms of another currency. The value of cedis to dollars, dollars to pounds, cedis to CFA, etc. are all examples of exchange rate trades. It affects every aspect of our lives, from the price of fuel to the cost of food products, basic amenities, etc.
A strong currency suggests that more goods can be bought with a given currency. For imports, a stronger exchange position ensures that more goods can be purchased per unit using a given currency. On the other hand, a weak exchange rate suggests that a currency has less purchasing power, which means less commodities/services purchased per unit. Of note, net exporting countries (who export more than import) prefer weaker currencies, since that allows them to sell more; while net importing countries (that import more than they export) prefer stronger currencies.
Why It Matters
The world today is a global village, where nations are growing increasingly dependent on each other as a result of trade. Trade enables countries to sell or purchase goods/commodities depending on advantage(s) to a given economy. Thus, countries decide to sell goods in which they typically have lower costs of production per unit, and buy goods that are more costly to produce. To trade, countries hold reserves of other currencies in their central banks, which sells them on the open market through commercial banks.
What Impacts the Exchange Rate?
There are a host of factors that impact the exchange rate (and the value of a currency, by extension). Prominently, the balance of trade, rate of inflation, and economic growth are some of the key factors that impact the exchange rate. Of the above, inflation–which refers to price increases in goods and services–is arguably the most impactful. Inflation reduces the value of a currency, that is, its purchasing power. This means that the higher the rate of inflation, the lower the value of a given currency (depreciation). On the other hand, the lower the rate of inflation, the stronger the value of a given currency. For this reason, central banks strive to curb inflationary spirals in order to maintain healthy trade positions.
Key Takeaways
The exchange rate measures the value of one currency in terms of another. It determines the capacity of a country to trade on the global market. Importantly, there are a number of factors that impact the value of a currency, including inflation, economic growth, and balance of trade.