The Significance of the Exchange Rates: A Survey of the Literature

Emmanouil Karakostas

Department of International and European Studies, School of Economics, Business and International Studies, University of Piraeus, Piraeus, Greece.

DOI: 10.4236/me.2021.1211082                

Abstract

Since the collapse of the Bretton Woods in the late 1970’s, the international monetary system has been dominated by the floating exchange rate system. The currencies around the world are mainly determined by the laws of the supply and demand. International trade has been the engine of growth and the cause of stability in many countries. International trade flows have increased extremely over the last three decades. The reduction of trade and policy barriers have contributed in the rise of global trade, but the interesting question is if the exchange rates play any role in international economic relations. An important aspect of the relationship between the exchange rates and the international economic relations is the intensity of the effect. To examine the intensity of this relation, we must mention the connection among exchange rates with the economy and trade. Due to the fact every country—developed or developing—targets economic growth, the investigation of the relationship of the exchange rate with the economy is important. Moreover, the exchange rate affects the trade volume and the current account, so the exploration of the exchange rate with the trade performance is necessary. The aim of this paper is to survey the economic literature on the relationship between exchange rates and global economic relations.

Keywords

Exchange Rates, International Economy, International Trade, Literature Review

1. Introduction

The current international economic system is highly globalized. The exchange rate is highly important¹. The importance of the exchange rate is due to the participants and characteristics of the market (Kallianiotis, 2013). Another reason of the significance of the exchange rate is the importance of the exchange rate for both as macroeconomic policy variable and as variable for business operations (Moosa, 2000). The worth of the exchange rate as an instrument of economic policy is mentioned by Pilbeam (1991). Exchange rates are very essential for the economy² of a country. As an economic policy³, exchange rate⁴ management seeks to improve the competitiveness of a state. Guzman et al. (2017) state that a stable, competitive, and effectively multiple exchange rate can promote economic development. Due to the instability of global financial markets, flexible and sustained interventions are needed. Moreover, they mention that all these interventions have to be along with, and in coordination with, a range of other monetary, macro-economic and micro-instruments.

The literature⁵ about the relationship between the exchange rate and economic relations is mostly mixed and vast. The central feature of the relationship between the exchange rates and global economic relations is the intensity of the effect. In some cases, the intensity is immense and in some other cases insignificant. To comprehend this intensity, we must cite firstly, the relation of the exchange rate with the economy, by mentioning the role of exchange rate in growth, for both developed and developing countries and the magnitude of the exchange rate pass-through. Secondly, we must cite the relation of the exchange rates with trade performance, by mentioning the relationship of the exchange rates with the volume of trade, the role of the exchange rate in the current account and by mentioning the sectors of production.

This paper will try clarifying the significance of the exchange rates, by mentioning the impact of the exchange rate pass-through and the magnitude of the sectors of production. This paper differs from previous papers in that it seeks to describe exchange rate relations in a broader context⁶. The remainder of this paper is structured as follows: in the second part, the relation between exchange rates and economy is cited. In the third part of this paper the role of the exchange rates in the performance of trade is cited. In the end, concludes with a discussion of problems that remain to be addressed. This research was based on the research of the literature⁷.

2. Exchange Rates and Economy

Growth is one of the main economic objectives of each country. The truth is that the exchange rate policy is critical macroeconomic policy. Making the best use of the exchange rate can help achieve economic growth. A country’s exchange rate policy is essentially the main driver of a proper and appropriate balance between monetary and trade policy. Regarding the role of the exchange rate to growth Table 1 shows the indicative literature about the relation of the exchange rate and growth.

The use of the exchange rate plays a significant role in growth. A key point is the role of the exchange rate in developed and developing countries. That is, how to exchange rate policy as a tool of economic policy effect developed and how developing countries? The role of the exchange rate in developed and developing countries is shown in the following table. Table 2 shows the authors and the main conclusions regarding the exchange rate in developed and developing countries.

Table 1 shows that the exchange rate is a significant variable for growth. As we can see from Table 2, the exchange rate is important for both developed and developing countries. The intensity of the exchange rate volatility may be different. What is the main reason for this difference?

The exchange rate pass-through is the factor which makes the difference. Why the exchange rate pass-through is significant? The phenomenon of the exchange pass-through is crucial. The exchange rate regime is critical for the economy of a country. Either fixed, or floating the stability of the exchange rate is more proper.

Table 1. The relationship between exchange rate and growth.

Source: (Author’s elaboration, based on the literature).

Table 2. The authors and the main conclusions regarding the exchange rate in developed and developing countries.

Source: (Author’s elaboration based on the literature).

The exchange rate pass-through is actually the influence of exchange rate variations on national inflation, so the pass-through is an important factor regarding the monetary policy (Takhtamanova, 2008). Table 3 shows the authors and the main conclusions regarding the Exchange Rate Pass-Through.

The appropriate monetary policy of a country and the imported inflation can be the two reasons that the exchange rate pass-through is important for understanding the intensity of the relationship between the exchange rate and international economic relations. Every country—developed or developing—aims to achieve economic growth. The exchange rate policy is a critical variable to achieve growth. Many developing countries for example don’t have strong macroeconomic variables and are prone to inflationary pressures. To attain economic growth every country must apply the proper exchange rate policy and restrict the negative effects of the exchange rate pass-through.

Table 3. The authors and the main conclusions regarding the exchange rate pass through.

3. The Relation of the Exchange Rates with the Trade Performance

The exchange rate regime⁸ is a choice which can help the volume of trade for any country. Either the choice of the exchange rate regime⁹ the main point is that the exchange rate plays an important role in the volume of trade. Table 4 shows the authors and the main conclusions regarding the Exchange Rate and the Volume of Trade.

The exchange rate is significant regarding the volume of trade. But, is a little bit obscure whether the exchange rate volatility is negative or positive as far as the volume of trade. To comprehend this relationship, is proper to mention the relation between the exchange rate and the current account. Table 5 shows the relationship between the exchange rate and the current account.

It is obvious that the exchange rate is crucial concerning the current account. But what is the reason for the diversity concerning the impact of the exchange rate to the trade flows. The question can be the following: Which goods and services are more prone to volatility? The answer could be the different productive sectors. Table 6 shows the relationship between the exchange rate and the productive sectors.

The difference among the productive sectors is important. As we can see from the above table the diverse products may have altered impacts. For example, agricultural products and tourist services are more vulnerable than high-tech products. The exchange rate is significant as far as trade performance. The exchange rate can assist the trade flows, it cannot alter the production of a country. So, the characteristics of the production are vital.

4. Conclusion

From the research of the literature, we can make two major conclusions. The first one is that the variety of the effects depends on the type of commercial goods and services. The exchange rate movements affect trade performance either robustly either not. That depends on the nature of the products or other characteristics of the markets and the domestic economy. For example, the services, agricultural products and the energy products have major interdependence with the exchange rate, rather than for instance, the products of high technology.

Table 4. The authors and the main conclusions regarding the exchange rate and the volume of trade.

Source: (Author’s elaboration, based on the literature).

Table 5. The authors and the main conclusions regarding the exchange rate and the current account.

Source: (Author’s elaboration, based on the literature).

Table 6. The authors and the main conclusions regarding the exchange rate and the productive sectors.

Source: (Author’s elaboration, based on the literature).

The second conclusion is that the exchange rate pass-through is an important factor for the economy of a country. The imported inflation and monetary policy are of great importance. It is not accidental that many countries have applied inflation targeting policies. Amongst the factors that drive economic growth is certainly the appropriate exchange rate policy.

The exchange rate is a key tool of economic policy. It should not be assumed that exchange rate policy can determine a country’s trade potential. The exchange rate assist trade, it does not change it. In particular, where a country relies heavily on intermediate inputs it should keep the exchange rate as stable as possible because exchange rate volatility will burden the prices of intermediate goods resulting in the passing on of the exchange rate. Still, a country should try developing goods and services with more and more technological inputs because the added value of products makes them less prone to currency shocks.

What determines the positive, the negative or the neutral relationship between the exchange rate and the economic activities of a country? The answer to this question is not easy. The literature is mainly mixed and obscured. But we can conclude that the monetary policy, the imported inflation and the differentiation of the products are some important variables. Further research on the linkage of the exchange rate with the economy is needed.

NOTES

¹Many empirical studies have shown the effect of the fluctuation of exchange rates on exports, trade, investment, capital market, inflation, and employment growth in developing and developed countries (Schnabl (2008); Jamil et al. (2012); Rjoub (2012); Allen et al. (2016); Dal Bianco and Loan (2017); Latief and Lefen (2018); Vo et al. (2019); Hatmanu et al. (2020); Ioan et al. (2020).

² Chowdhury (1993) mention the negative relation between exchange rate volatility and the volume of exports. Dell’Ariccia (1999) found a negative effect of exchange rate uncertainty and trade. Bleaney & Greenaway (2000) found a negative relationship between exchange rate volatility and investment. Grydaki & Fountas (2008) cite that the level of the exchange rate is affected by monetary and price shocks. Also, is affected by shocks in government spending, output demand and the trade balance. Vidyavathi et al. (2016) argue that the relationship between exchange rate and the related macro-economic factors causing variability in the value of the exchange rate is important in any country. Morana (2007) mentions that the linkages between macroeconomic and exchange rate volatility (for the G-7 countries), are the output and the inflation volatility in particular, and money growth volatility at a lower extent. Ehrmann & Fratzscher (2004) found out that not only monetary policy and macroeconomic variables have a substantial impact to the exchange rate but also the news about macroeconomic variables plays a major role.

³ Bernhard & Leblang (1999) refer that politicians’ incentives play a significant role in the choice of an exchange-rate arrangement. Frieden (1997) reports the “monetary populism” as a politics instrument concerning inflation or deflation, Frieden (2002) refers to the differently driven private interests which are urged by the real effects of currency policy on trade and investment and Frieden et al. (2001) suggest the role of the government with support in the legislature on choosing the exchange rate regime. Klein & Marion (1997) reports that the possibility of a devaluation rises straightaway when an executive transfer occurs.

⁴The exchange rate management restrains the three main aspects of the relationship. Nicita (2013) mentions the aspects of the relationship between exchange rates and trade, which are: first, the volatility (the risks and the transaction costs that reduce trade), second, the currency misalignments (the impact of the misalignments on relative import prices) and third, the effect of the misalignments on trade policy (indirect influence on the government assessments).

⁵ Auboin & Ruta (2011) and Ozturk (2006) give a detailed literature review.

⁶Research such as Auboin & Ruta (2011) and Ozturk (2006) mainly study the effects of exchange rate volatility on the volume of international trade and the impact on international trade of exchange rate volatility and of currency misalignments. This study covers a broader and total analytical framework such as economic growth, trade volume, exchange rate pass-through, current account and productive sectors.

⁷This paper reviews part of the relevant academic literature that attempts to model and estimate the role of exchange rate in international economic relations. The review, therefore, abstracts from other important factors that may have a bearing on the role of the exchange rates such as the impact of the monetary policy, the factors behind the determination of exchange rates, the relationship between exchange rate policies and global imbalances, the factors behind the current accounts, and the factors of different production capacities of each country.

⁸ Klein & Shambaugh (2006), argue that the fixed exchange rate regime (pegging) is preferable and more conducive to the increase of trade. Pozo (1992) refers that both fixed and perfectly flexible are favorable to trade, but the managed floating regime is not beneficial for trade. Brada & Mendez (1988) found that bilateral trade flows among countries are boosted with floating exchange rates. Broda (2004) gives an explanation about the trade performance and regimes in developing countries. When a fall in the terms of trade is occurred, the small and slow real depreciation witnessed in pegs is because of the fall in domestic prices. The large and immediate real depreciation in floats echoes a large nominal depreciation.

⁹In their paper, Bordo & Schwartz (1997) report that two types of regimes have prevailed in history. The first one is based on convertibility into a commodity, general species, and the other is based on fiat. The first one prevailed in the US in various guises until Richard Nixon closed the gold window in August 1971. The latter is the standard worldwide in nowadays. Rogoff et al. (2003) using primarily the Natural classification to make some points. The intermediate regimes remain prevalent, especially among emerging markets and other developing countries. Moreover, freely floating regimes remain rare. The two main exchange rate regimes, before the current exchange rate system are the Gold Standard and the Bretton Woods. One advantage of the gold standard is that it can function as a trustworthy anchor for monetary policies, and consequently for inflation expectations (Cheng et al., 2010). The Bretton Woods offered a nominal anchor and robust stabilization, as well as, stable and firm monetary policies which were not instantaneously counter-balanced by adjustments in wages and costs (Kirrane, 1995). After the collapse of the Bretton Woods system the exchange rates are “floating”. The classification of the exchange rate regime can be done by the “Natural” Classification by Reinhart & Rogoff (2002). The Natural Classification divides the exchange rate regimes into five categories—fixed, limited flexibility, managed floating, freely floating and freely falling—and 15 subcategories.

Conflicts of Interest

The author declares no conflicts of interest regarding the publication of this paper.

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