Factors Affecting International Agreements And Political Economy: Essay On Exchange Rate, Purchasing Power Parity, And Terms Of Trade. (70 Characters)

Overview of factors affecting relative prices of commodities

Question:

Discuss About The International Agreements Political Economy?

The objective of this report is to provide an overview on the main factors affecting relative prices of commodities. Fluctuations in prices are upward or downward swings in commodity prices in the economy. A significant part of the price differences between the countries are the terms of trade of goods and services, fluctuations in exchange rate, wage compression etc.  The causes of price fluctuations between the nations focus on the factors that impact the prices of tradable products, mainly services, as the price divergence apt to be eroded in the traded industry of the nation (Frank, Bernanke and LUI 2015)  An exchange rate refers to the price of the country’s currency with respect to another country’s currency. Exchange rates are mainly determined in foreign exchange market.  Relative prices of products and services are vital for determining changes in exchange rates over long periods. Purchasing power parity (PPP) signifies that the exchange rate between currencies is equivalent to ratio of currencies. It is determined in every nation based on their cost of living as well as inflation rates.  This economic theory however compares various nations’ currencies through basket of product approach. Terms of trade (TOT) indicates the prices of country’s exports relative to their import prices. Fluctuation in terms of trade leads to changes in prices of exports and import goods.  Foreign exchange market refers to the market in which the participants of the nation have the ability to purchase, sell, speculate and exchange on the currencies (Frenkel and Johnson 2015).  The operations of foreign exchange market mainly includes- transfer of funds between two nations, providing short term credit to importers to increase the flow of products between countries and hedging risk of foreign exchange. The central banks of the respective nation plays vital role in this foreign exchange market. These banks control supply of money, inflation, and interest rates. They utilize foreign exchange reserves for stabilizing market. The government usually intervenes in the FX market in order to influence exchange rate level and stabilize it for improving the health of the nation.

There are several factors that influence foreign exchange rates. Fluctuations in relative price level of goods and services are one of the main factors that affect the foreign exchange rates. If the nations do not impose restrictions on trade, the exchange rate between these two nation’s currencies is permitted to adjust accordingly. Moreover, if the transport cost of products between the nations is nil, then exchange rate between currencies might reflect differences in level of price in these two nations.  The theory of purchasing power parity mainly compares the relative prices of goods between the nations. Gopinath, Helpman and Rogoff (2014) propound that fluctuations in level of product prices brings about variation in foreign exchange rate. Similarly, fluctuations in exchange rates might result to variation in relative price level. Hence, this theory assumes that there has been direct linkage between FX rate and purchasing power of the nation’s currencies.  In addition, amendment in international prices of products and services creates movements in the exchange rates and vice versa. This means that if there is decline in exchange rate, the relative price level of foreign products and services increases. On the other hand, if there is an increase in exchange rate, then relative prices of foreign products will increase.

Exchange rate and its impact on foreign exchange rates

The foreign exchange rate apt to rest at that point that signifies equality between purchasing powers of two currencies. This particular point is referred to as the PPP. Under autonomous paper standards system, the currency’s external value mainly depends on the purchasing power of this specific currency with respect to another currency (Mankiw 2014).  However, under such system, exchange rate is mainly determined by PPP of various currencies in different nations. The actual exchange rate between the nations seldom reflects two currencies purchasing power. The reason behind this is that the government of respective nations has either control exchange rates or prices or inflicts restriction on both export as well as import of products. Thus, changes in FX rates tend to impact on the PPP.

The terms of trade usually measures the exchange rate of one commodity for another when trade occurs between two nations. The Foreign exchange rate has huge influence on terms of trade. In general, weaker currency enhances exports and makes imports highly expensive.  Volatility in rate of exchange is mainly caused by variation in terms of trade as increase in value of the currency of the nation reduces domestic import prices but might not directly impact on the export product prices. Reduction in exchange rate decreases terms of trade while appreciation in exchange rate increases terms of trade. Melvin and Norrbin (2017) states that, direct as well as indirect impact of change in exchange rate leads to change in trade surplus or trade deficit.  It has been stated Reisman (2013) that, depreciation in exchange rate should be sufficiently huge to cause impact on the balance of trade. In the short run, the balance in trade will deteriorate the import value in foreign currency that is multiplied by magnitude of rise in foreign currency price.  According to standard theory of trade, the balance of trade is predicted to be directly influenced by depreciation. This theory also defines that the balance in trade in the nation is supposed to rise after depreciation in real exchange rate.  Menkhoff (2013) found out that depreciation in foreign exchange rate influences terms of trade.  

The terms of trade is mainly determined by each nation’s reciprocal demand for the commodity of other nations.  Moreover, reciprocal demand is governed by demand as well as supply conditions. Therefore, the demand intensity by other nations for a particular nation’s exports and the demand intensity for imports from other nations are the vital factors, which determine terms of trade.  Apart from this, cost conditions of the exported commodities and that imported have also vital role in terms of trade determination.

Concept of Purchasing Power Parity (PPP)

Intervention in the foreign exchange market refers to the monetary policy tool at which the central bank takes participatory role for impacting transfer rate of monetary fund of the country’s currency (Noussair, Plott and Riezman 2013). Intervention in FX market usually comes in two sections, which includes-

• Firstly, the nations that are highly dependent on exports and deals with appreciating currency, the government might try to intervene. Therefore, by weakening their currency, they are making export products highly competitive in global market.
• Secondly, there are times when intervention might be short time reactionary for particular event. However, these events might cause the nation’s currency move in particular direction in less time space.

There are certain circumstances at which the government of the respective nations intervenes in the FX market in order to influence exchange rate level.  The government adopts certain methods for influencing exchange rate, which includes-

• Reserves as well as borrowing- If the government wants in maintaining original value and exchange rate value decreases, then it might use foreign exchange reserves.
• Varying interest rates- Rise in interest rates causes flow of money as well as increase sterling demand (Melvin and Norrbin 2017). Moreover, it does not have impact on depressing demand in the nation. In this case, the government might be reluctant to reduce demand for increasing the currency value.
• Borrowing- At times, the government might borrow foreign currencies from the foreign countries.
• Reducing inflation rate- The government might decrease aggregate demand through tighter fiscal or monetary policy.

Therefore, the main reasons for which government of respective countries intervenes in the foreign exchange market are given below:

• In order to correct for failures in the market
• In order to reverse growth in respective nation’s deficit in trade
• In order to enhance the performance of the nation.

The government of the respective countries achieves following objectives by intervening in the FX market-

• Exchange rate stability
• Prevention of undervaluation or overvaluation of nation’s currencies
• Reserving exchange for vital imports
• Encouraging as well as protecting domestic industries
• For improving balance of payments
• For curbing conspicuous consumption
• For regulating export and securities transfer
• For repaying their foreign loans

Conclusion

From the above study, it can be concluded that there are several reasons for fluctuations of prices between the nations such as exchange rate, terms of trade etc. Relative prices fluctuation is one of the factors that affect foreign exchange rate. The factors that affects changes in FX rates includes- supply as well as demand of commodities, inflation rate, political and economic stability and government debt. Moreover, the government also intervenes in the market for improving the economic health of the nation by stabilizing exchange rate, repaying foreign loans, improving balance of payments etc.

References

Frank, R.H., Bernanke, B.S. and LUI, H.K., 2015. Principles of economics. McGraw-Hill Asia.

Frenkel, J.A. and Johnson, H.G. eds., 2013. The Economics of Exchange Rates (Collected Works of Harry Johnson): Selected Studies (Vol. 8). Routledge.

Ghosh, A.R., Ostry, J.D. and Chamon, M., 2016. Two targets, two instruments: monetary and exchange rate policies in emerging market economies. Journal of International Money and Finance, 60, pp.172-196.

Gopinath, G., Helpman, E. and Rogoff, K. eds., 2014. Handbook of international economics (Vol. 4). Elsevier.

Mankiw, N.G., 2014. Essentials of economics. Cengage learning.

McKinnon, R.I. and Ohno, K., 2016. 7 Purchasing power parity as a monetary. The Future of the International Monetary System: Change, Coordination of Instability?: Change, Coordination of Instability?, p.42.

Melvin, M. and Norrbin, S., 2017. International money and finance. Academic Press.

Menkhoff, L., 2013. Foreign exchange intervention in emerging markets: a survey of empirical studies. The World Economy, 36(9), pp.1187-1208.

Noussair, C.N., Plott, C.R. and Riezman, R.G., 2013. The principles of exchange rate determination in an international finance experiment. In International Trade Agreements and Political Economy (pp. 329-368).

Reisman, D., 2013. The Economics of Alfred Marshall (Routledge Revivals). Routledge.

Rios, M.C., McConnell, C.R. and Brue, S.L., 2013. Economics: Principles, problems, and policies. McGraw-Hill.

Taussig, F.W., 2013. Principles of economics (Vol. 2). Cosimo, Inc..