International Monetary SystemHow Exchange Rates Influence Business ActivitiesA country with a currency that is weak (valued low relative to other currencies) will see a decline in the price of its exports and an increase in the price of its imports. A company improves profits if it sells its products in a country with a strong currency (one that is valued highrelative to other currencies) while sourcing from a country with a weak currency.Exchange rates affect the amount of profit a company earns from its international subsidiaries. The earnings of international subsidiaries are typically integrated into the parent company’s financial statements in the home currency. Translating subsidiary earnings from a weak host country currency into a strong home currency reduces the amount of these earnings when stated in the home currency. Likewise, translating earnings into a weak home currency increases stated earnings in the home currency. The intentional lowering of the value of a currency by the nation’s government is called devaluation. The reverse, the intentional raising of the value of a currency by the nation’s government, is called revaluation.Devaluation lowers the price of a country’s exports on world markets and increases the price of its imports because the value of the country’s currency is now lower on world markets. But devaluation reduces the buying power of consumers in the nation. Revaluation has the opposite effects: It increases the price of exports and reduces the price of imports.Desire for Stability and PredictabilityUnfavorable movements in exchange rates can be costly for domestic and international companies alike. Although methods do exist for insuring against potentially adverse movements in exchange rates, most of these are too expensive for small and medium-sized businesses. Moreover, as the unpredictability of exchange rates increases, so too does the cost of insuring
against the accompanying risk. By contrast, stable exchange rates improve the accuracy of financial planning and make cash-flow forecasts more precise.Managers also prefer that movements in exchange rates be predictable. Predictable exchange rates reduce the likelihood that companies will be caught off guard by sudden and unexpected rate changes. They also reduce the need for costly insurance (usually by currency hedging) against possible adverse movements in exchange rates. Rather than purchasing insurance, companies would be better off spending their money on more productive activities, such as developing new products or designing more-efficient production methods.What Factors Determine Exchange Rates?To improve our knowledge of the factors that help determine exchange rates, we must first understand two important concepts: the law of one price and purchasing power parity.