Terms Beginning With 'e'

Exchange Rate

  • October 27, 2020
  • Team Kalkine

What is meant by Exchange Rate?

Exchange rate refers to the value at which one currency can be measured against another currency. They are significant for open economies as they allow countries to trade, and they are important indicators of an economy’s well-being.

Exchange rates help determine the relative strength of currencies, and subsequently, the relative strength of the respective countries. In simpler terms, an exchange rate is a price in a domestic currency which one must pay to acquire a foreign currency. The higher the exchange rate, the higher is the variation in the strength of two currencies. A lower exchange rate value indicates that both currencies are relatively at par with each other.

For instance, an exchange rate value of EUR/USD = 1.19 means that 1 Euro is worth 1.19 USD. Effectively, this implies that 1.19 USD must be paid to obtain 1 Euro, or 1 Euro must be paid to receive 1.19 USD.

What are the different types of exchange rates?

There are two broad categories under which exchange rates are maintained – fixed exchange rate and flexible exchange rate. Countries have the provision of keeping an exchange rate that lies in between these two extremes.

  1. Flexible or Floating Exchange Rate: This is the type of exchange rate regime where the market forces have relatively higher control over the exchange rate compared to the central bank and monetary authorities. The demand and supply of foreign exchange determine the exchange rate system under such a regime.

These exchange rates are ‘flexible’ and vary with market forces. As a result, they fluctuate with time. However, under tight circumstances when the exchange rates fall too low, central banks have the provision of intervening and stabilising the rates.

A floating exchange rate reflects, more effectively, how the economy is performing. Since there is no constant regulation of authorities, flexible exchange rates adapt faster to economic changes in the home country than fixed exchange rates.

Some of the currencies that follow a flexible exchange rate are Canadian Dollar, US Dollar, Pound Sterling, Japanese Yen and Australian Dollar.

Most international markets observe a floating or semi-floating type of exchange rate. The regime adopted by the Canadian Dollar can be considered the closest a currency can get to a fully floating exchange rate.

  1. Fixed Exchange Rate: This type of regime includes continuous regulation by the authorities to keep the exchange rates fixed to a particular level. This regime is followed by those nations which possess enough foreign exchange reserves to influence their supply in the home country.

With adequate reserves of the foreign currency, it is possible to affect the exchange rates. If the domestic currency depreciates, the central bank can sell the foreign currency in exchange for the domestic currency.

Some of the currencies that follow a fixed exchange rate are the Saudi Arabian Riyal, which is pegged to the US dollar, the Danish Krone which is pegged to the Euro, the Hong Kong Dollar which is pegged to the US Dollar and many more such currencies.

How are exchange rates determined?

The demand and supply of foreign currency determine the exchange rate in a floating exchange rate environment. Currency appreciation refers to the increase in the value of a currency with respect to a foreign currency. On the other hand, currency depreciation refers to the decrease in the value of a currency with respect to a foreign currency.

Consider the following example that shows how the exchange rate of Dollar in terms of Euro is determined. The supply of Euro refers to the quantity of Euro available as foreign exchange, while the demand for Euro reflects its demand in the domestic country.

Image Source: © Kalkine Group 2020

Considering the above diagram, the supply of Euro in the economy is increasing, while the demand for the Euro remains the same. As more and more units of Euro are accumulated as foreign exchange, Euro depreciates while Dollar appreciates.

Now consider the following example when the domestic demand for Euro rises. Here the increased demand for Euro leads to a depreciation of Dollar while the Euro appreciates. Thus, the exchange rate of Dollar vs Euro rises.

Image Source: © Kalkine Group 2020

Apart from these natural shifts, countries can also manipulate exchange rates. It is possible to change the value of the domestic currency with respect to foreign currency by changing the supply of foreign exchange reserves of the latter. This method is used by central banks of various countries to devalue or revalue their domestic currency.

If the current exchange rate is maintained at 2:1, the home country can just announce that the value of the domestic currency will be devalued to 10:1. This is known as devaluation. This further decreases the value of the domestic currency. Further, if the central bank announces that the exchange rates will be maintained at 7:1 then this is called revaluation.

What is an Absolute Advantage? Absolute advantage is one of the key macroeconomic terms, which is based on the principles of Capitalism and is often utilised in international trade-related decisions. Absolute advantage refers to the competence of a company, region or country to produce goods or services in an efficient manner compared to any other economic entity. The efficiency in production can be achieved by: Production of the same quantity of good or services as produced by other entity by utilising fewer amount of resources Production of a higher quantity of good or services as produced by other entity by using the same amount of resources What is the Significance of Absolute Advantage? Different countries or businesses possess a different set of ability owing to their location, soil composition, weather, infrastructure, or human resource skills. When applied in the right direction, various factors may pan out to offer more cost-effectiveness and hence build absolute advantage of the entity in comparison to others.  The absolute advantage remains one of the critical determinants for the choice of the goods or services to be produced. Absolute advantage in a particular area often translates into profitability in the area. The profit margin increases by the achievement of cost efficiency, allowing the entity to ensure higher profitability over the competitors.  For example, let us assume that the US can produce ten high-quality aircrafts utilising a specific amount of resources. China, on the other hand, can build 6 similar quality aircrafts using the same amount of resources. Thus, in the production of an aircraft, the US holds Absolute Advantage Let’s say the US has the ability to manufacture a certain amount of steel using 10 tonnes of iron ore. China, on the other hand, can produce the same quantity of steel using 8 tonnes of iron ore.Here, China here holds Absolute Advantage in the production of steel.  How Countries Build Absolute Advantage? While natural conditions, which include climatic factors, geometry, topography, cannot be altered for achieving absolute advantage, the countries use the underlying factors strategically in their favour. Furthermore, factors of production are focused at by many companies or nations for building absolute advantages.  Some of the strategies for building absolute advantage includes: Development of Technological Competencies- The implementation of innovative or latest technological innovations allows the entities to lower their production cost, facilitating absolute advantage.  Enhancing Skills of Human Resources- The improvement in the cost-efficiency, along with the quality of the products, is targeted through imparting varying skill development programs. Many countries subsidize or aid the apprentice or labour training for enhancing the absolute advantage in trade.  Improving Infrastructure- The infrastructure enhancement in the form of road, telecommunications, ports, etc. can be useful in enhancing the cost-effectiveness across different industries.  What Do We Understand by Comparative Advantage Vs Absolute Advantage? Evaluating the comparative advantage introduces the concept of opportunity cost, which is the deciding factor to determine the production of particular goods or services. Opportunity cost refers to the potential benefits associated with the next best possible alternative which is missed out when one option is chosen over another.  The Absolute advantage simply considers the capability of a business or region to deliver goods or services in the most efficient manner. The Comparative Advantage, however, also takes into account the benefits that are forgone if an entity decides for production of a particular product or services.  Comparative advantage, based on the notion of mutual benefits, is often used in international trade deals. The Comparative advantage has been the major factor driving the outsourcing of services in search of cheap labour.  Understanding through an Example For instance, country A can produce ten televisions with the same amount of resources with which it can make 7 laptops. The opportunity cost per television is 7/10 or 0.7 laptops. Meanwhile, the opportunity cost per laptop is 10/7 or 1.42 television.  It highlights that country A is forsaking the production of 0.7 laptops if it is deciding to manufacture one television. On the other hand, it is missing out the opportunity to manufacture 1.42 televisions for every single laptop manufactured.  Now, say Country B’s opportunity cost for producing a television is 0.5 laptop, and that of producing laptop is 2 televisions. Then, country B will have a comparative advantage in making televisions, and country A will have comparative advantage in producing laptops. It has to be noted that despite country A having absolute advantages in both the products, it would be mutually beneficial for both the countries if country B produces television while country A produces laptops. Do You Know About Absolute Advantage Theory by Adam Smith? The concept of Absolute Advantage was indicated by Adam Smith in his book called ‘Wealth of Nations’ which focusses on International trade theory. Adam Smith, in his book attacked on the previous mercantilism theory, which mainly stressed for economies to maintain trade surplus in order to command power.  The Absolute Advantage theory considered that the countries possess different ability with respect to the production of varying goods or services. It argued that it is not necessary that a state may hold an absolute advantage in the production of all goods, and here the relevance of trade comes into play.  It advocates that countries should produce those goods over which they hold a competitive advantage. It would allow the countries to make the same amount of goods using few resources or in less time. The theory propagates the relevance of trade for economic sustainability.  What Are the Limitations of the Absolute Advantage Theory? The assumptions used in the Absolute Advantage Theory by Adam Smith may limit the application in real bilateral trade. The limitations of the theory by Adam Smith include: Smith assumed that the productive capabilities of a country could not be transferred between the two countries. However, in practical terms, the competitive scenario aids the nations to acquire new capabilities and acquire new resources, especially in the technological and human resource skill aspects.  The two-country trade which was used as a basis for the theory does not consider the trade barriers levied. The present scenario, however, is strikingly dominated by trade wars between economies. Nations impose huge tariffs, import duties and other type of barriers to promote local manufacturers.  Absolute Advantage theory assumes that the trade between the two nations will take place only if each of the two economies holds an absolute advantage in one of the commodities traded. However, in general, countries despite not holding absolute advantage are engrossed in international trade, boosting their economic setup.

Calculating the cost of a product or an enterprise based on the direct and the indirect costs (overheads) involved. Multiple methods of absorption costing include Direct labour cost percentage rate, Direct material cost percentage rate, Labour hour rate , Prime cost percentage rate and Machine hour rate.    

Refers to most commonly the realty sector and indicates the rate of sale of homes in a certain market during a given period of time. It is calculated as the ratio of the average number of sales in a month by the total number of available homes.

Net amount after factoring in all debits and credits in a financial repository at a given moment. If an account balance drops below zero, it demonstrates a net debt.

We use cookies to ensure that we give you the best experience on our website. If you continue to use this site we will assume that you are happy with it. OK