Exchange Rates in Economics

Exchange Rates

• Exchange rate is the price of one currency in terms of another, equivalent to the foreign currency that can be obtained from a unit of home currency.
• In economics, exchange rates are reported in terms of home currency per foreign currency (e.g., Naira per foreign currency).
• For example, N350 Nigerian Naira is equivalent to 1 US Dollar.
• Exchange rates can be quoted in European terms, i.e., 1/350 = 0.0077 N/$.
• Exchange rates can result in gains or losses for organizations that receive and/or make payments in foreign currencies.

Exchange Rate Determination

• Exchange rates can be determined by the foreign exchange market, which is open to various types of buyers and sellers and operates continuously.
• In a floating exchange rate regime, exchange rates are determined by market forces of supply and demand.
• Countries can impose limits and controls on exchange rates, and governments can choose to have a floating, pegged, or hybrid exchange rate regime.

Types of Exchange Rates

• Spot exchange rate is the current exchange rate.
• Forward exchange rate is an exchange rate quoted and traded today but for delivery and payment on a specific future date.
• Buying rate is the rate at which money dealers will buy foreign currency.
• Selling rate is the rate at which money dealers will sell that currency.
• Quoted rates may incorporate an allowance for a dealer's margin or profit.

Exchange Rate Regimes

• Countries can choose from three main types of exchange rate regimes: free-floating, pegged (fixed), or a hybrid.
• Free-floating regimes allow exchange rates to vary according to market forces.
• Pegged regimes involve fixed exchange rates, but with provisions for revaluation (usually devaluation) of a currency.
• Hybrid regimes combine elements of free-floating and pegged regimes.

Exchange Rate Classification

• Buying rate: The price used by banks to buy foreign currency from customers, where a smaller amount of domestic currency is required to buy a certain amount of foreign exchange.

Bank Foreign Exchange Trading

• Selling rate: The price used by banks to sell foreign exchange to customers, indicating how much domestic currency is required to recover a certain amount of foreign exchange.
• Middle rate: The average of the bid and ask prices, commonly used in newspapers, magazines, and economic analysis.

Delivery-Based Classification

• Spot exchange rate: The exchange rate for spot foreign exchange transactions, delivered within two working days, and generally listed on the foreign exchange market.
• Forward exchange rate: An agreed-upon exchange rate for a certain period in the future, with a premium, discount, or parity based on the spot exchange rate.

Exchange Rate Setting

• Basic rate: The exchange rate based on a key convertible currency, usually a world currency, which is widely used for pricing, settlement, and reserve currency.
• Cross rate: The exchange rate calculated through the basic exchange rate, resulting in the exchange rate of the local currency against other foreign currencies.

Payment Method-Based Classification

• Telegraphic exchange rate
• Mail transfer rate
• Demand draft rate

Foreign Exchange Control-Based Classification

• Official rate: The exchange rate announced by a country's foreign exchange administration, usually used by countries with strict foreign exchange controls.
• Market rate: The real exchange rate for trading foreign exchange in the free market, fluctuating with changes in supply and demand conditions.

International Exchange Rate Regime

• Fixed exchange rate: A fixed exchange rate between a country's currency and another country's currency, with minimal fluctuations.
• Floating exchange rate: A regime where the monetary authorities do not stipulate the official exchange rate, allowing for fluctuations without upper or lower limits.