How Foreign Exchange Affects the Economy

Foreign exchange identifies the process of converting domestic currency into international banknotes at particular exchange rates. These transactions present distinct ramifications for the global economy. Foreign exchange rates affect international trade, capital flows and political sentiment. Further, you should work to understand the economic risks associated with foreign exchange and globalization, prior to coordinating financial decisions.

Foreign exchange rates describe valuations for domestic currency, which describe the economic and political standing of your home nation. Low exchange rates may signal recession and political instability. Alternatively, strong exchange rates often serve as an indicator of favorable commercial conditions for a particular country. Exchange rates directly impact international trade. Low exchange rates support tourism and the export economy. At that point, domestic goods become less expensive for foreign buyers. Domestic consumers, however, prefer higher exchange rates. Consumers then have more purchasing power to spend on imported goods.

Foreign exchange rates influence capital flows, or investment funds that move into and out of a country. Nations with rapidly deteriorating currency values are less attractive to foreign investors. At that point, foreigners liquidate their stocks, bonds, and real estate, because these assets are losing purchasing power relative to competing investments in other currencies and countries. International savers prefer to purchase investments in countries that feature stable and appreciating exchange rates. Foreigners are more comfortable making overseas financial commitments when they feel that value will be preserved--as international profits are eventually converted back into their home currency.

Foreign exchange rates carry important political implications. Citizens may point to unfavorable exchange rates and trade imbalances as signs that politicians currently in office are mismanaging the economy. Voters will then agitate for economic reforms and changes in leadership. Politicians may react by proposing domestic tax cuts, while legislating for import duties and quotas designed to protect the economy at home.

The orderly dissemination of exchange rates through organized currency markets leads to increased globalization. Globalization refers to the integration of separate nations, regions and cultures within the world economy. This trend improves the spread of technological innovations, expands markets and creates jobs for the international labor pool. Globalization contains inflation--because the increased competition for jobs and market share places downward pressure on prices.

Globalization is associated with contagion, or the spread of financial panic and recession throughout the world. For example, the value of the Mexican peso may collapse due to sovereign default and credit crisis in that country. International investors would then quickly liquidate their Mexican asset holdings. The fallout from Mexico reaches global proportions as savers speculate that all institutions doing business within Mexico are in jeopardy of bankruptcy. Foreigners are then likely to sell off all asset holdings, irrespective of geographic origin, to meet financial obligations and avoid potential losses. The selling pressure causes worldwide asset values to crash.