The exchange rate is the price of one currency in terms of another currency. Among all the prices present in the economic system it is perhaps the most important one, especially in economies that are highly open to the rest of the world. This is the case of the Italian economy, but also of all the other developed countries and almost all of the developing ones. In fact, the exchange rate influences the price and quantity of imported and exported goodsi, the balance of payments, the growth of the economy, the level of employment, inflation, the purchasing power of consumers and the profits of producers. In an economy where there is also the freedom of capital movements, that is, to buy, hold and sell freely foreign financial assetsthe exchange rate also greatly influences the value and profitability of these assets, capital flows and therefore the wealth of families and the indebtedness of companies.
Obviously each country has a different exchange rate with respect to each other nation’s currency. For example, in Europe we have the euro exchange rate against the dollar, the British pound, the Japanese yen and so on. However, given the central role that the American dollar plays in the international monetary-financial system in terms of invoicing currency, financing and commodity pricing, the exchange rate of the dollar against other different currencies is by far the most important. Therefore for Europe the Euro-Dollar exchange rate it is definitely the one where the greatest number of transactions are concentrated and where liquidity is most abundant.
Exchange rate: pay attention to the denominator
As we said the exchange rate is the price of one currency (euro) against another currency (dollar) and not the price of a good (a kilo of apples) against a coin. So you have to pay close attention to which currency serves as the denominator. In Europe, for example, it is customary to measure the exchange rate by evaluating how many dollars it takes to buy or sell one euro. Therefore, when we read or hear on the news that the dollar is trading at 1.08, we mean that it takes one dollar and eight cents to buy and sell one euro. In technical terms it is said that the euro quotes certainty for uncertainty. Many countries, however, quote their currency uncertainly for certain, i.e. amount of local currency to purchase one unit of foreign currency.
The euro-dollar over the last 25 years
In the graph we show the trend of euro-dollar exchange rate over the last twenty-five years, that is, since the birth of the single European currency in 1999. As we can observe, the dollar at the beginning of the 2000s, when the euro still had to gain a certain credibility, strengthened or revalued (fewer dollars were needed to buy one euro). Then the American currency weakened a lot until the financial crisis of 2007-2010 (it took more dollars to buy one euro). Since the European sovereign debt crisis, the dollar, albeit with various fluctuations, has remained rather strong.
Since today transactions of a financial nature (purchases and sales of shares, bonds and other financial assets) are far more frequent and extensive than those of a real nature (the exchange of goods and services), movements in exchange rates are most influenced by relative interest rates, from operators’ expectations and risk aversion, than from real variables such as income, relative inflation or international trade flows. In this context it is easy to understand how the relative monetary policies adopted by central banks play a crucial role.
Exchange rates and central banks
When talking about exchange rates it is good to underline the term relative, since what matters is not the level of interest rates but the interest rate differential or the different degree of expansion/restriction of countries’ monetary policies. Last week, for example, the European Central Bank it cut its interest rates before the US Federal Reserve Bank and therefore the dollar appreciated.
From the end of the Second World War until the beginning of the seventies the central banks and governments of the main countries had adopted fixed exchange rates against the dollar, which in turn was pegged to thegold. This stability favored post-World War II growth, however it could not withstand the repeated shocks that followed, excessive American public spending in the years of the Vietnam War and the liberalization of capital movements in many economies.
Since the fall of the fixed exchange rate system in 1971, Europe has repeatedly tried to maintain a certain stability of exchange rates among the countries that make up the European Union. The great dream of having a single currency was then crowned in 1999, when the various national currencies (Italian lira, French franc, German mark, etc.) were replaced by the Euro. Thus today we can travel more freely, exchange goods and services and financial activities in Europe without paying attention to exchange rate movements and the related risks they entail. We can also count more on the international scene and feel more proud of being European.
Three final considerations deserve to be made regarding the exchange rate risk borne by investors. First, it is interesting to note that the variability of exchange rates, which has been constantly decreasing for many years, is on average lower than that of financial assets (shares, bonds, gold, etc.). Secondly, the correlation between financial assets and exchange rates it is in many cases negative. For example, a fall in the interest rate causes the price of bonds and stocks to rise but the exchange rate to depreciate. Third, there are efficient foreign exchange markets in the market risk hedging instruments. Thus, careful international diversification of the financial portfolio should not overly scare investors who can draw undoubted benefits from it.
