Rate of exchange plays an important role in the performance of an open economy. Its importance is listed as follows:
1. When it is regulated, it provides authorities with a powerful policy instrument with which to influence the terms of trade with the objective of deriving maximum possible gains from its economic transactions with rest of the world.
2. When it is left to be determined by market forces, it is one of the important determinants of the competitiveness of a country’s products in international markets.
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3. Variations in exchange rate exert a direct impact on the gains of a country from its economic transactions with rest of the world.
4. It is an indicator of the comparative health of open economies.
5. Rate of exchange of a currency has a two-way relationship with the economy of its origin; it is influenced by the efficiency of the ‘home’ economy vis-a-vis that of the other economies and, in turn, influences the working and performance of the ‘home’ economy.
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6. It is a conversion factor by which prices of goods in one currency can be expressed in units of the other. This makes it possible to compare prices of similar goods in two or more countries and help exporters and importers in assessing the profitability or otherwise of trade deals.
Consequently, changes in exchange rates have the potential of altering the volume, composition and direction of external trade of a country and may be used as a policy weapon.
Similarly, rate of exchange and its behaviour exert their impact on international flows of capital and investment.