Exchange rate policy: What is it and how does it affect the commodity market?

Exchange rate policy is a set of measures taken by the government or central bank to influence a country’s exchange rate. The aim is to avoid sharp fluctuations, such as a sharp depreciation or appreciation of the currency, which could create economic imbalances against other foreign currencies, especially the US dollar.

The exchange rate is volatile, influenced by political and economic events around the world. Exchange rate policies are the tools used to reduce this volatility and ensure greater economic stability. In this text, we will understand the main types of exchange rate regimes, how this policy is applied in practice and its impact on the commodities market. Enjoy the read!

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• The Impact of Brazil’s Monetary Policy on the Commodities Market

What are the goals of exchange rate policy?

Exchange rate policy aims to balance different economic aspects of a country according to the value of its currency. The main objectives include:

• Controlling inflation – When a currency depreciates against others, the price of imported products becomes more expensive. An efficient exchange rate policy helps to avoid large fluctuations in the prices of goods and services.
• Currency Balance – Exchange rate policy seeks to balance purchasing power to maintain export competitiveness without significantly affecting inflation.
• Attract foreign investment – A stable exchange rate environment attracts international investors by reducing the risks associated with currency fluctuations.

Exchange rate policy in practice:

To achieve these goals, each country’s central bank uses different exchange rate tools. Here are the main ones:

Interest rate adjustments – This is one of the most important methods of economic control of a currency. Higher interest rates can attract foreign investors and strengthen the local currency. On the other hand, lower interest rates can encourage domestic consumption, accelerating the domestic economy.

Buying and selling foreign currency – A country’s central bank may intervene in the foreign exchange market by buying or selling currencies. Trading dollars (or other foreign currencies) in the market helps to control the supply and demand for the local currency.

Currency swaps – Contracts entered into by the central bank to protect against exchange rate fluctuations without directly changing international reserves. This tool is a hedging product that helps to protect the parties involved financially.

Foreign Capital Restrictions – Another tool that the government can use is to limit or encourage the entry and exit of foreign capital. This strategy also affects the supply and demand of the local currency.

Tax Incentives – A country’s government may also offer tax incentives for foreign investment in certain sectors. The goal is to increase the inflow of dollars, thereby increasing the value of the local currency.

The main exchange rate regimes

There are three types of exchange rate policies that a country’s central bank can adopt. Learn more about each:

• Fixed exchange rate: The value of the national currency in relation to foreign currencies is fixed. The intent is to set a fixed price for trading between one currency and another.
• Floating exchange rate: The value of the currency is determined by the market, according to supply and demand. In this case, there is no government intervention in the price of trades. Despite being a more volatile regime, it allows for adjustments to economic conditions.
• Managed exchange rate: also known as exchange banking or hybrid exchange rate. It works as a combination of the above two regimes. The central bank allows the currency to fluctuate within a minimum and maximum range and intervenes when necessary to correct major imbalances.

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• Understand monetary policy and the weight of Asian rates in the foreign exchange market

How does currency policy affect the commodities market?

The commodities market is global, with trade agreements between countries that use different currencies. This makes the sector particularly sensitive to exchange rate fluctuations. Below we will understand how exchange rate policy affects the price of these commodities:

Export Competitiveness

An appreciated currency increases the purchasing power of a country’s domestic population, but makes exported products more expensive. A depreciated currency makes exports more competitive but reduces purchasing power.

Cost of Production

One of the most important commodity groups is agriculture. Much of this and other sectors consume imported products, such as fertilizers and machinery. In this scenario, a depreciated currency means higher production costs. The currency’s relationship to the dollar

In the commodities market, most goods are traded in dollars. As a result, interest rate adjustments in the U.S. can affect the value of the dollar in the marketplace and, consequently, the purchasing power of other currencies. A stronger dollar tends to make commodities more expensive for countries with weaker currencies, reducing global demand. On the other hand, a weaker dollar can stimulate consumption, increasing the price of those commodities.

Also read:

• Understanding the Federal Reserve’s (FED) Influence on the Brazilian Economy

The Importance of Hedging for Financial Protection

As exchange rates fluctuate, monitoring exchange rate policy is essential for companies that want to remain competitive and profitable in a globalized market. In this scenario, hedging tools are essential to meet the challenges posed by exchange rate volatility. At Hedgepoint, we have experts in currency hedging and customized solutions to meet the needs of the commodity market. Contact us through our website and talk to our team!