Internal Exchange Rates Definition | How it Affect Us

Internal Exchange Rates Definition

In our globalized 21st century, large price disparities still survive within the same economy: domestic exchange rates. In this article we analyze what they are and how they affect us. In recent decades, the process of economic globalization that the world has experienced, especially in terms of the internationalization of production processes and the liberalization of the movement of people, capital and goods, has intensified the interdependence of national economies. However, there are still large differences in the cost of the same products from one country to another that cannot be explained exclusively by the different value of their currencies: these are internal exchange rates.

These types, defined as the general level of prices and wages prevailing in each economy, can vary even between countries that use the same currency, and in some cases also from one region to another of the same country. As a consequence, domestic rates influence issues as fundamental to an economy as the purchasing power of its citizens (it is important to remember that price levels also include wages, since these are the labor factor), Competitiveness of its exports or its ability to attract foreign investors.

Why Internal Exchange Rates Exist?

As we have discussed above, internal exchange rates may vary from one region to another within the same country, but perhaps the clearest example of this disparity is the euro-zone. In this case, the adoption of a common currency by 19 countries is an experience with few precedents in economic history, especially if we remember that its main objectives are to ensure monetary stability and to facilitate the integration of national economies into a single market regional. From a theoretical point of view, we could expect that the elimination of the different national currencies would solve the divergences in the exchange rate, and that in a fully integrated market (assuming also perfect information) the price and wage disparities would tend to disappear.

Secondly, if we analyze the particular situation of the economies where there has been convergence (also considering other factors such as their geographical proximity), we also see that they are countries with a high degree of interdependence. The clearest case of this mutual dependence is Belgium and the Netherlands, whose divergence in prices went from 3.2 percentage points to only 1.1 since the adoption of the euro, which shows that when two economies are fully integrated, the Elimination of external exchange rates results in almost complete price convergence.

This is not the case for the more peripheral euro-zone economies, which seem to have experienced some convergence only in the early years of the euro, in order to stabilize later. In this way, we observe how the price level of Finland is still 47% higher than that of Greece, and even between countries with strong economic ties like Italy and Spain there are notable differences. Taking into account that the degree of interdependence between the peripheral economies is much lower than between the central ones, we could conclude that this is one of the factors that explain the existence of internal exchange rates.

This explanation is perfectly aligned with what is advocated by economic theory: if two economies with different price levels form a single market (i.e. free movement of people, capital and goods) and there is perfect information, market agents Of the country with higher prices will seek to source on the other to reduce their production costs and increase their profit margins. In this way, the country with lower prices would be benefited by an increase in exports and by the inflow of foreign capital oriented to investment. These factors would generate inflationary pressures, which, added to the deflationary tendency of the neighboring country (that would be suffering the opposite effect, that is to say.

However, it should be noted that interdependence, while undoubtedly a decisive factor in the understanding of internal exchange rates, is also not a sufficient explanation. If this were the case, prices in Spain would eventually equal those in France, as the Spanish economy would benefit from the relocation of French production and an increase in exports to the Gallic country. On the other hand, the empirical evidence tells us that the divergence in prices has hardly changed since 2002, which is not unnatural if we consider the differences between the two countries in the value added of their economies. Simply put,

Finally, we find a factor no less important in the particularities of the national economies. In this sense, the existence of differences in the fiscal framework and labor regulation, or the implementation of national price policies (whether inflationary or internal devaluation) may restrain the convergence between interdependent and value-added economies similarly.

How do Internal Exchange Rates Affect Us?

The existence of internal rates (which, as we have said, are not only national but also regional or local) usually have a strong impact on the economies of the countries. On the one hand, it increases the relative purchasing power of countries with high rates, as it allows them to buy, invest or tour in the lower types at more competitive prices. However, they may also be adversely affected at times, as their domestic economy may be subject to some dumping by foreign suppliers. On the contrary, countries with low rates can strengthen their economic growth thanks to the foreign sector, but will see their capacities reduced when they go abroad.

In this sense, it is important to remember the differentiating role of added value, since the countries that have opted for this route have managed to maintain a better level of wages without risking dumping or destroying jobs. By contrast, many of the countries that have opted for competitiveness via costs have been forced to boost their exports with policies of internal devaluation, entering a vicious circle that can translate into falling wages and purchasing power, saving and increasing debt and external dependence. In other words,

In conclusion, we can say that internal exchange rates are determined by the three factors mentioned (economic integration, the added value of productive activities and the peculiarities of economies), and that they may be responsible for serious structural imbalances if they are fixed artificially. However, they can also lead to great opportunities if they are accompanied by free and flexible markets that tend to integrate the different economies into a single market and thus achieve convergence in prices. This is perhaps the true paradox of internal exchange rates: unlike other growth factors, domestic rates can be very beneficial to the economy, but only to the extent that they can disappear.