Exchange rate affects an economy because it has a direct link to the currency of the nation and can determine the economic condition of the nation involved.
Exchange rate of a national currency relative to another currency has a direct bearing on the national economy because of bilateral trade relationship between both countries. For instance right now about 400 Nigerian naira exchange for one US dollar. The bilateral trade between both countries will be on the basis of that exchange rate. If by tomorrow the rate changes to 500 naira per dollar, the balance changes even more in favour of the US economy and the Nigerian economy suffers more.
Exchange rate can be understood as the number of units of domestic currency required to purchase one unit of the foreign currency. When the exchange rate of the foreign currency rises with respect to the domestic currency, more number of units of domestic currency are required for one unit of the foreign currency, meaning thereby that the country has to pay more for its imports, which will disturb its balance of payments situation & reduce its foreign exchange reserves. This has impact on the entire economy. All imports, foreign currency loan & interest payments are affected - the country has to pay more for them. It affects the inflation rate too (Purchasing power parity theory).
A fluctuating (unstable) exchange rate leads to unstable economy whereby it becomes difficult to predict value of goods, services and the likes. This can also affect quantity and cost of import and export of such country
When exchange rate of a country increases relative to others (currency devaluates) the export of the country whose currency devaluates will be cheaper for others. Therefore, export is expected to increase and imports will decrease. Similarly when exchange rate decreases relative to others exports are discouraged and imports will be encouraged. Therefore, exchange rates play significant roles in determining country's' trade balance.
If you go through some papers on the money-inflation relationship e.g(, Aizenman et al. (2010) ) have found that countries with exchange rate stability tend to have low inflation. So what will happen when there is no exchange rate stability and inflation is out of control? The implications to the economy will be devastating.
Arun Vishnu Kumar, I wish add at your good answer as follow.
In the case of Trade Chanels effect we will can study regional and sectorials effects. These effects does part of a chain of events, especially importants when any region has a natural resource boom: this phenomena is named Dutch Dissease. I was research the Colombian case and actually I am research the Peruvian case. I have found that the regional dutch dissease effects of natural resource boom are:
1. Decrease the local currency.
2. All regional sectors handelbarers drecease in level of production or regional sectors handelbarers growth rate decrease in comparison with the past.
3. All regional sectors non-handelbarers increse in level of production and the these regional sectors will have a higher growth rate in comparison with the past. /other effect are migration and urban growth near of mines or Oil Wells.
4. The previous three point implies that countries with natural resource booms Should pay special atention to regions with natural resource booms and make a Regional Development Strategy for this or these regions.
I am sorry because i do not know a good english yet. But here one of my research in Spanish.
http:// online.unisc.br/acadnet/anais/index.php/sidr/article/view/13444
Hello Charity Ezenwakwelu, how are you? everything ok? The exchange rate have so many efects, hows depends first of the economical estructure of the country. One country whit internal industrial estructure more integrate and complet, and a agricultural powerfull in food suplies and inputs, will have efects less intense efects them in other country whit a poor industrial and agricultural estructure.
And why this efects? imagine a country like Brasil, where the industrial estructure is organizated basic whit multinational industry hows takes whit outdoor countrys the great part of his inputs, principal the high tecnological ones. Whem a rise of the exchange rate starts at a country like brazil, the efect is not just the protection of the domestic market, whit the consequent enhancement of the imports. because of the moust part of the components of the industrial production are imports, made by the multinational industrys on his international sistem of suplies and production. On this way, the raise on exchange rate whill results in a raise of the internal cost productions, hows depends of the dependence of the industrial domestic system of the outdoor suplies. Because of this is likely the rise of exchange rate will results in a double direct efect: 1) the protction domestic market; 2) the rise of the internal cost productions.
For a better analisys of this dynamics is better to work whit de real exchange rate, and compare thi whit the real exchange rate of the other countrys. How whe can do this? Taken the rise of exchange rate, and subtracting the rise of domestic inflation, you gone find the real exchange rate. Comparing this one, whit the variation of the real exchange rate of other countrys, you whill find the real efects of the rise of this. for a better and more abrangent analisys, is possible to make a international agregat variation of the international real exchange rate, ponderated by the size of the economies. if your rise is bigger than in other countrys, the efect will probably results in a decrease of the economics grow. If you wants a a development strategy is good to tink in politics hows protects the dormestic production without rise the inflaction rate.
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