Foreign Exchange Rate. How Global Currencies Work

The national currency rate on the international exchange reflects the state of the country’s economy. The exchange rate has an ambiguous effect on the functioning of the economic system: any change in its dynamics is accompanied by a variety of macroeconomic effects that carry both a stabilizing and a destabilizing effect. In this regard, the study of factors affecting changes in the exchange rate seems relevant, as well as the conditions of its formation.

Background and State of the Art

Strengthening the exchange rate is a normal process for countries catching up with development aimed at reducing their backlog. Competition due to the artificial understatement of the national currency is price dumping, which does not stimulate the growth of quality, production efficiency, and welfare of the population. Relying on this policy in the medium and long term means participating in a race to lower wages with poor countries with an excess of cheap labor (Evans, 2017). This will require an ever stronger understatement of the real exchange rate and wages, low consumption standards.

In the modern world of global production chains, the exchange rate is no longer a source of competitiveness for a growing number of goods. It is rare if an industrial product is entirely developed and produced in only one country. Competition in the modern world is shifting towards competition in terms of quality, technology level, and product image (Eichengreen et al., 2017). A country’s attempts to compete only in price will ultimately lead to an increase in technological lag (Habib et al., 2016). There is a risk that an increase in production at rate undervaluation will not be accompanied by an increase in wealth and will be unstable (Huber, 2014). In the modern world, a steady increase in the country’s wealth requires integration into global production chains at an ever higher level of creating added value, where the level of the national currency is of secondary importance.

Although most countries of the world apply exchange rate regimes, in the last decade increasingly more countries are moving to flexible currency regimes – for example, Brazil, Israel, Poland, Chile (Frieden, 2016). This trend is likely to continue, because in the context of growing international relations, countries with rate binding regimes are exposed to an increasing risk associated with the variability of capital flows. Flexible currency regimes, as a rule, ensure higher level of protection with regard to exogenous shocks and greater independence of monetary policy.

Results and Discussions

The currency exchange markets in emerging economies and in the majority of developing countries are narrow and inefficient. This situation, to some extent, is determined by the fact that they place too much emphasis on foreign exchange regulation. Exchange rate rigidity also hinders the development of the exchange market, as market participants have less incentive to study exchange rate trends, open positions or manage risk (Battilossi et al., 2020; Frieden, 2016). In addition, a central bank that uses a fixed rate regime is usually forced to act on the market itself, which limits interbank activity.

In this regard, among the measures that countries can take with the aim to deepen the market, there is reducing the role of the central bank as a market maker, including quoting buying and selling rates, since playing such a role reduces the field of activity of other market players (market makers). Instead, the central bank can stimulate market development by minimizing its own operations with banks and accepting established market prices (Simpson, 2014; Kallianiotis, 2013). For example, in Turkey, after the floating lira exchange rate was introduced in early 2001, the central bank gradually abandoned market operations, forcing market participants to trade with each other (Eichengreen et al., 2017). As the experience of Mexico, Turkey, and Chile shows, official interventions are not always an effective tool for influencing the exchange rate or reducing volatility (Evans, 2017). In reality, interventions often only lead to increased exchange rate volatility.

A feature of pricing in today global foreign exchange market is that the same factors have different effects under different conditions (Jedlinsky, 2015). It is necessary to know the interconnection and mutual influence of various currencies, the history of their development, to determine the combined result of various economic measures, and to establish a connection between events that are absolutely unrelated at first glance. At the same time, economic factors are of priority importance, but it concerns not specific macroeconomic indicators. Rather, it is about the presence of a stable trend and a noticeable growth rate or decrease of one or another indicator. Although economic factors are crucial for the global foreign exchange market, especially in the long run, non-economic factors, political or psychological, sometimes play an important role in pricing in the foreign exchange market (Mishkin, 2015). For example, the European currency decreased by 21.7% in the currency reserves of the countries by 2015 (Eichengreen et al., 2017). Eichengreen et al. (2017), explaining this phenomenon, claim that this decrease in the share of the European currency by 12% compared to 2011 is explained by the drop in the stability of the euro due to the difficult economic, migration and geopolitical situation in the European Union. Top currencies by foreign exchange market turnover are presented on Figure below.

Top currencies by foreign exchange market turnover in April 2016
Fig. Top currencies by foreign exchange market turnover in April 2016

The main currency used in the private sector as a means of settlement is the US dollar. Although the formation of the euro zone took place, which provides a significant contribution to the creation of the world product, as well as the inclusion of the Chinese yuan in the world reserve currencies, and an increase in the share of China in world production to the level of the euro zone, any really obvious increase in the share of the common European and Chinese national currencies was not observed. This situation is explained, first of all, by the action of external network effects (network externalities), which means the inertial behavior of world market participants when choosing international currency unit in the short term.

The system of national currency regulation as an instrument of monetary policy, of course, must exist and be maintained. At the same time, one cannot expect from this system such results as the cessation of the export of capital, or the supply of foreign currency in any conditions. It serves, rather as an absorber of external shocks and as a market stabilizer, which does not allow for an increase in panic. It cannot affect macroeconomic factors, but only mitigates their impact in the short term. The rigidity or liberality of the regulatory system depends on the state of the national financial system, world markets, and the direction of current economic policy.


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Eichengreen, B., Mehl, A., & Chitu, L. (2017). How global currencies work: Past, present, and future. Princeton University Press.

Evans, M. (2017). Studies in foreign exchange economics. World Scientific Publishing.

Frieden, J. A. (2016). Currency politics: The political economy of exchange rate policy. Princeton University Press.

Habib, M., Mileva, E., & Stracca, L. (2016). The real exchange rate and economic growth: Revisiting the case using external instruments. European Central Bank Working Paper Series, 1921. Web.

Huber, J. (2014). Modern money theory and new currency theory. Real-World Economics Review, 66, 38-57.

Jedlinsky, J. (2015). Currency systems and their role in entering and leaving the economic crisis. Chinese Business Review, 14(4), 169-185.

Kallianiotis, J. N. (2013). Foreign exchange rate determination. In: Exchange rates and international financial economics. Palgrave Macmillan.

Mishkin, F. (2015). The economics of money, banking and financial markets. Pearson.

Simpson, T. D. (2014). Financial markets, banking, and monetary policy. Wiley.

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