IV. Correlation between the exchange rate and the term of trades and the government intervention: Exchange rate and term of trades The rate of inflation in a country can have a significant influence on the value of the country’s currency as inflation is closely related to interest rates, which can affect exchange rates. As the currency depreciates, the cost to their foreign consumers falls and people are likely to buy more, which in turn translates to higher profits, production, employment, and higher output, leading to higher inflation. There are four different economic factors that have a major impact on the exchange rate movement through their effects on demand and supply conditions, which are inflation rates, interest rate, income levels and government controls (Somanath, 2011). These factors can actually draw a change in the international trade or financial flows; thus, the demand for a currency or the supply of currency for sales is affected, as well as the equilibrium exchange rate. If an interest rates in foreign country suddenly increase, then: the inflow of U.
S. funds to purchase its securities should appreciate; the outflow of its funds to purchase U.S. securities should depreciate; and an upward pressure on its currency’s equilibrium value might therefore happen (Somanath, 2011).
In order to measure the benefits a nation obtains from specialization and trade, the terms of trade ratio are used so that a country can determine the cost whether it is worth to trade internationally or just satisfy its own needs (Vélez-Hagan, 2015). Especially in a developing small economy, the primary internal component of the real exchange rate is the relative price of goods, as a weak real exchange rate in a country that runs a persistent trade surplus may affect several factors (Lane and Milesi-Ferretti, 2002). 2. Government intervention The trade theories discussed assume that there is no government intervention; however, in reality, there is always some level of government intervention in trade, which will result in the distortion of the price structure. Firstly, the government will secure domestic employment as high unemployment is significantly unsatisfactory for any government.
The import of equality products from low-wage countries may result in the closure of some local non competitive firms, leading to an upward in unemployment. Secondly, the government will protect domestic industry against foreign competitors who might be able to develop the same goods more competitively and at a more reasonable price because of lower labor costs. Transferring resources to the industries in which a country has a provisional advantage and where labor productivity is high will improve the wage structure as well as the living-standard in the long term.
For example, in New England, industries such as electronic or software have created many well-paying jobs and increased the standard of living in the region (Asgary, Frutos-Bencze and Samii, n.d.). Finally, the government will strengthen government income by exercising import taxes and tariffs, which means creating a bias in the consumption pattern and artificially manipulating the consumers’ choices. A suitable policy would be for the government to organize an impartial and effective tax system and collection process. V.
ConclusionIn conclusion, exchange rates play an important role in a country’s level of trade, which is significantly important to watch, analyze and measure the manipulated economy by the government to almost every free market economy. Despite the fact that there are numerous complex factors among many determine exchange rates, the rate of inflation in a country can have a major impact on the value of the country’s currency, but is more likely to have an absolute negative effect. Having a low rate of inflation does not ensure a favorable exchange rate for a country, but having an extremely high inflation rate is most likely to affect the country’s exchange rates with other nations negatively. Therefore, investors and governments should still have some understanding of how currency values and exchange rates play an important role in the rate of return on their investments, so that they can prepare a suitable plan when there are changes.