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About exchange rate

How the exchange rate is formed

After the abolition of the Bretton Woods currency system, which was adopted in 1944 and ensured the peg of the dollar to gold (1 troy ounce was worth $ 35), and the rest of the currencies - to the dollar. In the period from 1971-1976. the Jamaican currency system was adopted, according to which exchange rates began to be calculated on the basis of supply and demand, that is, according to market rules. If demand exceeds supply, then the exchange rate rises, and if supply dominates demand, it decreases. But how to understand under what conditions the prerequisites for the growth of demand are created, and under what conditions - the supply? In this article, we will describe how banks set exchange rates and maintain them at a certain level.

Purchasing Power Parity

Today, money is the same product that can be bought for the money of any other country at the corresponding exchange rate, and for the currency acquired in this way, to purchase goods and services issued by the corresponding country. Moreover, the currencies of some countries are estimated more expensive, others - cheaper, that is, the amount of production for these currencies can be obtained differently, and all countries are somehow involved in foreign economic activity. In this connection, such a concept as purchasing power parity (PPP) arises - the ratio of currencies of different countries, established by their purchasing power in relation to a certain set of goods and services. Accordingly, it is extremely important to understand how the exchange rate is considered. Allocate freely convertible currencies (without any restrictions for transactions for non-residents) and currencies having restrictions on its conversion.

How the bank sets the exchange rate

Demand and supply (and, accordingly, the exchange rate) are formed through political and economic factors, which, in turn, can be interconnected. The most significant factor is the actions of central banks on monetary policy. Central banks make interest rate decisions to adjust exchange rates and other economic indicators. Accordingly, if the rate decreases, then the currencies of the corresponding country become larger, as enterprises begin to take “cheap” loans for their development. Such measures are often used to stimulate the economy.

As the money supply becomes larger, then it starts to cost less. If the economy shows good growth rates, then central banks begin to raise rates, thereby making money more “expensive”. As a rule, at lower rates inflation begins to rise, which can be described as the percentage of annual depreciation of money. If you imagine a situation in which an investor needs to invest in another country's currency, most likely the investor will choose the currency that will depreciate less, thereby creating additional demand for it. That is, lower inflation is favorable for the exchange rate, and vice versa, high inflation helps to reduce the value of the country's currency. But inflation, in turn, is a kind of barometer of economic activity - the higher economic activity, the more money the country's population has, the more they want to buy, creating demand, pushing prices up. In this case, central banks begin to raise rates, controlling the process.

Fig. 1. Adoption of the QE III Program in the USA

It turns out that central banks set exchange rates, carefully observing published macro statistics. Strong reporting may indicate a possible acceleration of inflation and create a need for higher rates, which, in turn, makes this currency more interesting to purchase, pushing its rate up. At the same time, low macro statistics may indicate the need for additional measures by the Central Bank to reduce the rate, which will create an offer for this currency, pushing its rate down.

The most significant indicators are GDP, industrial production, price indices (essentially characterizing inflation), unemployment data, dynamics of sales and stocks. Based on all these factors, the Central Bank’s exchange rate is established.

But there is another indicator of macro statistics, which is worth talking about separately. This is the balance of payments - the movement of funds in the form of payments from and to the country over a certain period of time, expressed in the form of their difference. If the balance of payments is positive, then this means that other countries are buying the currency of the country in question to purchase goods and services produced on its territory, which pushes the course up. If the balance of payments is negative, the country must sell its currency for foreign in order to purchase imported goods.

In addition to statistics, political factors influence exchange rates. Thus, the stability of the state contributes to an increase in its exchange rate, while instability, on the contrary, reduces the rate of a given currency. Moreover, the most developed economic states formed reserve currencies - globally recognized currencies purchased by central banks of other countries as strategic investment assets (gold and foreign exchange reserves). Reserve currencies are used to determine currency parity and are used for international settlements. Currently, the functions of reserve currencies are performed by the US dollar, euro, pound sterling, Japanese yen, Chinese yuan. Naturally, to perform such an important function, the most stable currencies are chosen.

Also, to maintain the required exchange rate, central banks carry out foreign exchange interventions, that is, buying and selling foreign currency in order to maintain it in a favorable range. If the Central Bank of the Russian Federation buys dollars for rubles (for example, replenishing gold reserves), then the ruble exchange rate decreases, and the dollar grows (of course, in combination with the rest of the supply / demand for the specified currency). If the bank sells dollars for rubles, then the process of changing rates will be the opposite. From this point of view, we can distinguish currencies supported by the Central Bank of their countries in a certain corridor from minimum to maximum value and currency, with a free (market) process of forming their rates.

Exchange rates are changing and are in constant motion, sensitively reacting to changes in the economic situation, which, in turn, creates the basis for speculation with the currency. Understanding how the Central Bank sets the exchange rate, we can conclude in which currency it is more rational to store funds.

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