The exchange rates in the market are bilateral, that is, comparing the values of a currency against the other. However there is a need to compare a currency with that of several counties .Effective Exchange Rate refers to the index describing the strength of a county’s currency in reference to the basket with other currencies. Let’s assume a country has M trading partners denoted by Trade i and Ei representing the trade and the exchange rates with country i. The effective exchange rate will be calculated as:
E effective =E1Trade1Trade+. + EM TradeMTrade
The Effective exchange Rate is divided into two namely: The Nominal Effective Exchange Rate and The Real Effective Exchange Rate.
Nominal Effective Exchange Rate (NEER):
This is the simplest form of index. A country’s NEER is defined as the weighted average represented by its currency exchange rates compare to the currencies of its trading partners. The weighting/comparison is evaluated using the level of trade with each partner. Hence NEER provides a good view on the country’s currency changes resulting from the terms of trade. NEER is used as the basis of comparison for a country’s exchange rates relative to that if its partners.
The NEER is calculated as: i=14Wi/Ei
Where Ei =average period for nominal exchange
Wi= total trade weight
Real Effective Exchange Rate (REER):
REER is used in the comparison of the country’s real economic conditions. For example when a country’s NEER or the market rates shows downward trends it might be as result of other countries higher production rates. Secondly, REER could rise as result of inflation between the country and its trading partners. In short, REER is defined as the NEER minus the labor costs and the inflation rates. REER is the most appropriate measure of the country’s real economic activities between nations than the market rates.
The REER is calculated as: i=14NEERi*Ptradung PartnersPhome Country
The two formulae are used to calculate the NEER and REER values shown in the table below.
The paper will focus on the Finland’s Market rates between the years 1990 and 2013.Data to be used in the study represents the quarterly data (Q4) except the year 1990 with first quarter (Q1) recorded from IMF databank for market operations of the three countries. The paper would further examine several factors that influence the exchange rates among the trading partners. A comparison shall be carried with performance of its trading partners between the 1990 and 2013 as shown in the table below:
For exclusive comparison and analysis of the Finland’s market exchange rates in comparison to other trading partners like Norway and United Kingdom (UK) the data has been represented in the graphs below. The graphs represent NEER and REER rates respectively.
GRAPH 1: The Comparative graph showing the NEER for Finland and its trading partners (Norway and UK) between 1990 and 2013.
NEER Analysis and Discussion:
GRAPH 2: The Comparative graph showing the REER for Finland and its trading partners (Norway and UK) between 1990 and 2013.
Analysis and Discussion
The graph clearly shows the Finland’s Currency trend in the exchange market between a period of 1990 and 2013.In 1990, the REER of Finland of at its highest level than any of the other two currencies. This was followed by a dramatic depreciation in the currency value p to the year 1993, although its remained to be the market lead all this period. The study has also exclusively established the relationship between the NEER and the REET. It can be concluded that during the period the global market was faced by factors such as inflation, high labor costs, Economic depressions and political instability among other factors.
In 1994, the currency strengthened in the market than other two but was lather surpassed by the Euro in 1997.All through the entire period, the Finland currency remained stronger than the Norwegian dollar. As mentioned earlier the Real Effective Exchange Rates (REER) shows the real performance of the currency in the market. From the analysis, it can be observed that the Finland currency was not highly influenced by the market forces as it alternated around the 100 exchange rate mark. For example in both the NEER and the REER graphs, the exchange rates fluctuated slightly below or above the 100 index point while the Norwegian dollar and the UK’s Euro experienced high instability through the entire period.
The study assumes that the Finland’s central bank is too cautious /sensitive to the exchange market and responds to any slight market influences/forces.
In short the Finland’s currency enjoys the market exchange stability than its two trading partners.
Economic factors that influences the NEER AND REER of Finland’s Currency:
The REER and NEER are highly influenced by inflation, Tariffs and cost of exports and imports. These factors usually push the exchange rates to both directions that is the appreciation and the depreciation sides. Appreciation refers to the rise in value of a given currency while depreciation refers to the decline on the value of the currency. the graphs above show the relationship between the UK Pound, Norwegian Krone and the Finland’s currency.
Inflation is likely to result into depreciation of a currency’s exchange rates. The inflation is higher relative to the currencies of trading partners; the exchange rates tend to fall. The opposite is true during deflation: The currency’s exchange rates tend to increase. For example in the graphs we have seen the Finland currency rise above the other two. This can but explained using deflation scenario or economic recession while the Norway and UK currencies were still struggling to obtain currency stability. The lower the inflation rates results to the higher currency exchange values. For example a comparison between the Finland’s currency and the UK’s Pound under the NEER graph clearly shows that the Finnish Mark.
Secondly, when the tariff and policies are strict on the imports of goods in a country the Exchange rates will reduce. The same scenario is witnessed when the transaction fees/cost on the imports and exports are high.
Third, High interest rates influences the Exchange Rates to rise: Interest rates is a major factor used in the central banks to calculate the currency’s exchanges value comparative to that of the trading partners as it highly manipulates the economic policies. When the interest rates are lower, the currency can be easily accessible to the people and strengthens their expenditure. Likewise, lower interest rates are not welcomed by the lenders who are likely to hold on the money. As a result the currency will be scarce in the exchange market. The factors can be used to explain where the Finnish Mark trades higher than the Norwegian Krone in the exchange market.
Fourth, the Deficit accounts also influences the currency’s exchange rates: When the Current deficit accounts are high, the currency exchange rates fall while when deficit account is lower the exchange rates will rise. Under NEER of the three trading partners, the Finnish Mark enjoyed the highest rating at the beginning. The situation might have been as a result of the lower deficit account it held relative of its partners. As
Conclusion
The exchange rates are highly influenced by the market forces such as the inflation rates, Demand and supply forces, export and import policies, political and social forces, as well as the currencies of the trading partners. Through the comparative analysis of the market exchange rate, we have identified the relationship between the Finland’s currencies relative to that of the trading partners.
It is evident that among the three currencies, the Finland’s has been stable in the market for a longer period of time
Works Cited
