Exchange Rate And Foreign Direct Investment Economics Essay

To look at the exchange rate, we should look at the monetary value of a currency in footings of the sum of another currency we want to obtain. For illustration, how much of Euro should we give, to have an sum of 1 dollar in return? Economies operate under two types of exchange rates ; the fixed exchange rate and the flexible exchange rate. Countries that fix their currency to a currency of another state, is called the fixed exchange rate. This policy is non preferred by economic experts because it prevents domestic cardinal Bankss to put pecuniary policy ; nevertheless, there are advantages to this policy, which we will discourse subsequently ( Fixed Exchange Rate, par.1-2 ) . On the other manus, states that leave the value of their currency to alter in footings of other currencies, is called the flexible exchange rate.

In the long tally, exchange rate is said to be determined by the pecuniary theoretical account, which is related to money supply, end product degree of states, every bit good as market outlooks for future exchange rates. When these characteristics are combined, we will acquire the current exchange rate. Monetary theoretical account suggests that the exchange rate is determined by the comparative monetary value degrees of two states, which vary based on the demand and supply of money. If one kg of apples costs twice every bit much in Germany, so 2 Euro would purchase 1 kg of apples in dollars. Ceteris paribus, if the money supply in Germany additions, on norm, monetary values will be given to increase in Germany. However, because the monetary value degree in the US remains unchanged, more Euros will be needed to purchase 1 dollar. Furthermore, the Euro monetary value of dollars will increase, which in bend makes the Euro to deprecate and do it deserving less in footings of the dollar ( Hopper, 1997 ) .

In the short tally, nevertheless, the existent exchange rate is said to be the determiner ; it is the balance of a state & A ; acirc ; ˆ™s trade and payments. For illustration, when foreign currency is really plentiful like in Figure 1 ( big exports, capital influxs, or remittals ) , the market sets a low existent monetary value on foreign exchange.

Exchange Rate

Measure

Calciferol

S1

S2

Monetary value

or

Depreciation

Figure 1

Figure 2 shows the antonym. When a state has low exports or should refund large debts, the market sets a high existent monetary value for foreign exchange.

Exchange Rate

Measure

D1

S1

Monetary value

or

Appreciation

S2

Figure 2

When analyzing the existent exchange rate as the balance of a given state & A ; acirc ; ˆ™s trade and payments, we should see all influxs of foreign currency, every bit good as all escapes ( Harberger, 2008 ) . The same holds for the demand of a foreign currency. If demand additions, the currency will appreciate ( Figure 3 ) .

Exchange Rate

Measure

D1

D2

Second

Appreciation

Figure 3

If demand decreases, nevertheless, the currency will deprecate ( Figure 4 ) .

Exchange Rate

Measure

D1

D2

Second

Depreciation

Figure 4

Exchange Rate and Foreign Direct Investment ( Muamer Niksic )

As we have mentioned earlier, fixed exchange rate government has some advantages particularly when we deal with the foreign direct investings ( FDI ) . FDI under fixed exchange rate are hazard averse since it makes foreign investing safer with expected returns because the domestic currency will be fixed to the foreign currency. In the fixed exchange rate the figure of units of domestic currency needed to get foreign currency stays the same over the longer period of clip so investors can easy foretell the sum of income they will acquire after certain period terminals.

However, depreciation of the foreign currency in footings of domestic currency, under the flexible exchange rate government will besides do a certain market desirable for the possible foreign investors ( Exchange Rates and Foreign Direct Investment, p. 1 ) . This is caused by cheaper acquisition of production capacities internationally than on the local market. Such an investing will most probably convey higher net incomes. This is true merely for the short tally, while in the long tally such a anticipation may be wrong and cause losingss to the investors since under the flexible exchange rate, currency may appreciate over clip. Exchange rate uncertainness will impact the determination where will an puting company start runing abroad ; this is besides valid for the company & A ; acirc ; ˆ™s determination where it will sell its merchandises ( Hongmo and Lapan, 2000 ) . Selling goods in another market with different currency should besides number for differences in exchange rate.

We can state that there is a clear economic relationship between exchange rates and FDI because when a certain company invests in another state it should see exchange rates in order to properly calculate return on investing. The consequence of exchange rate may be positive or negative depending on grasp or depreciation of the currency and where finish state sells its goods.