Table Of Contents

Introduction..........................................................................................................................1

Main contents.......................................................................................................................2

1. What is the exchange rate?............................................................................................2

1.1. Definition of exchange rate....................................................................................2

1.2. Significance of exchange rate.................................................................................2

2. How is the exchange rate determined in the foreign exchange market?.......................3

3. Identify the balance of trade, nominal and real exchange rate......................................4

3.1. Balance of Trade.....................................................................................................4

3.2. Nominal Exchange Rate.........................................................................................5

3.3. Real Exchange Rate................................................................................................6

4. Distinguish between devaluation and depreciation of domestic currency....................7

4.1 Devaluation of Currency..........................................................................................7

4.2 Depreciation of Currency........................................................................................7

5. How can the State Bank of Vietnam help in bringing down the foreign exchange rate
which is very high?...........................................................................................................8

5.1. Tightening Monetary Policy...................................................................................8

5.2. Selling Foreign Currency Reserves........................................................................8

5.3. Widening the Trading Band....................................................................................9

5.4. Signaling Future Policy Intentions.........................................................................9

Conclusion..........................................................................................................................10

References..........................................................................................................................12
 Introduction

Exchange rates between currencies have become an integral aspect of the modern
globalized economy, enabling international trade and financial flows critical for growth
and development. An exchange rate is defined as the price of one currency expressed in
terms of another currency (Frankel, 2022). As key financial variables, exchange rates
influence flows of exports, imports, investments, tourism, remittances as well as overall
macroeconomic stability for nations.
Given deepening globalization over recent decades, exchange rates and their
dynamics have become more consequential worldwide. Fluctuations in currency values
impact the competitiveness and profitability of exporters, determine import costs,
influence foreign investment returns and outgoing remittance values in local currency
terms. For monetary and fiscal authorities, exchange rate stability concerns dominate
policymaking to avoid imported inflation, maintain international price competitiveness,
cushion currency mismatch risks for foreign currency debtors, and stem capital flight risks
during times of financial market volatility.
This essay seeks to elucidate the critical role of exchange rates along with the key
determinants and dynamics at play in currency markets. Core areas covered include -
definitions of exchange rates and their economic significance; exchange rate
determination in forex markets through demand and supply; concepts of balance of trade,
nominal and real effective exchange rates; distinctions between currency devaluation and
depreciation; and policy options for central banks to influence exchange rates. Recent
contexts of the Vietnamese Dong's sharp appreciation and State Bank of Vietnam's policy
options are also analyzed to offer timely insights into exchange rate management.
In a highly financially integrated world where a currency crash in a small nation
can have global contagion effects, the need for vigilance over exchange rate stability has
amplified. As such, this essay intends to shed light on the multifaceted dynamics and
policy dimensions around exchange rates - a crucial knowledge area for governments,
businesses and citizens navigating the complexities of modern international finance and
trade.

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2
 Main contents
1. What is the exchange rate?
1.1. Definition of exchange rate
An exchange rate is the price of one currency expressed in terms of another
currency (Frankel, 2022). It is the rate at which one currency can be exchanged for
another. Forex markets facilitate the buying and selling of different currencies, with
supply and demand determining the relative value and exchange rates between currencies.
For example, an exchange rate of 23,000 Vietnamese dong (VND) to 1 United States
dollar (USD) means that 1 USD can be exchanged for 23,000 VND.
Exchange rates fluctuate based on factors like relative inflation rates, interest rates,
economic growth rates, political stability, trade balances, and speculation (Frankel, 2022).
A high exchange rate means that currency is strong and valuable compared to other
foreign currencies, while a low exchange rate indicates that the currency is weak.
Understanding exchange rates helps governments, businesses, and individuals determine
the true cost of imported and exported goods and make informed financial decisions
involving multiple currencies. Stable exchange rates also promote international trade and
cross-border investments.
1.2. Significance of exchange rate
Exchange rates play a vital role in facilitating cross-border trade, investments, and
financial transactions in today’s globalized world (Madura, 2018). They determine the
competitiveness and profitability of a country’s exports, the cost of imports, and the value
of foreign investments and assets held abroad. As such, exchange rates significantly
impact the flow of goods, services, and capital between countries.
For exporters and importers, exchange rates influence achieved profit margins
through their effect on export revenues and import costs. Tourists and students studying
abroad are also affected as the purchasing power of their currency rises or falls. Even
ordinary citizens feel the impact of exchange rates on something as basic as the price of
imported fruits at their grocery store. For governments and central banks as well,
exchange rates are an important determinant of inflation, employment levels, trade
balances, and overall economic growth (Madura, 2018).

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 Maintaining relatively stable exchange rates through judicious monetary policies
and occasional currency market interventions allows businesses to invest confidently and
eases cross-border trade. In contrast, highly volatile exchange rates impede commerce and
cause uncertainties that can dampen economic progress. Understanding exchange rate
dynamics is therefore essential for crafting appropriate fiscal and monetary policies.
2. How is the exchange rate determined in the foreign exchange market?
The foreign exchange (forex) market is a decentralized global marketplace where
individuals, financial institutions, importers/exporters, corporations, and even
governments participate in the buying and selling of foreign currencies (Filardo et al,
2022). It is the world’s largest financial market, facilitating currency trading of over $6.6
trillion daily on average (Bank for International Settlements, 2019). This market
determines currency exchange rates based on the dynamics of supply and demand.
At its core, the forex market establishes exchange rates through an auction process
where participants bid on the price to buy (bid price) or sell (ask price) a currency pairing
(Madura, 2018). For example, a forex trader buys or sells the EUR/USD currency pair -
that is converting between Euros and US dollars at an exchange rate that fluctuates based
on supply and demand in the market. An increase in demand or decrease in supply of
Euros will bid up the EUR/USD exchange rate. The opposite market dynamics will bid
down the rate.
The major supply side determinants are cross-border transactions arising from
trade in goods & services as well as financial transactions involving foreign investments,
deposits, loans, or remittances (Filardo et al, 2022). For instance, European demand for
US debt securities or American imports from Europe creates Euro supply and Dollar
demand - appreciating the EUR/USD rate. On the demand side, expectations of currency
appreciation/depreciation, inflation rate differentials between countries, interest rate
differences driving capital flows, speculation based on economic or political news, and
interventions by central banks/governments influence forex demand (Madura, 2018).
In free floating regimes like most major economies, exchange rates are
predominantly determined by market forces of supply and demand without much central
bank intervention (Filardo et al, 2022). The US Dollar, Euro, British Pound, Japanese Yen

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all largely float freely based on forex market dynamics. But countries like China manage
their exchange rates more actively to maintain export competitiveness or economic
stability. Over long run, the theory of purchasing power parity provides an equilibrium
exchange rate benchmark - offering insights into when currencies might be over or
undervalued relative to fundamentals (Madura, 2018). But short-term daily price swings
are dominated by trader perceptions, speculation, and developments affecting currency
supply/demand.
Understanding forex dynamics is crucial for governments seeking to maintain
international trade competitiveness and stable import prices while maximizing foreign
exchange reserves. It helps multinational firms and institutional investors minimize
foreign currency risks when conducting cross-border business. For individuals, knowing
exchange rates facilitates money transfers abroad, international travel, or purchasing
foreign stocks/bonds. Ultimately the forex marketplace determines real-time currency
exchange rates every trading day based on the collective views of global market
participants bidding prices up and down.

3. Identify the balance of trade, nominal and real exchange rate.

3.1. Balance of Trade
A country's balance of trade (BOT) is the difference between the monetary value
of its exports and imports over a certain time period, typically one year (Madura, 2018).
Exports refer to domestically produced goods and services sold to foreign buyers, while
imports are foreign products purchased by domestic consumers and businesses.
A trade surplus exists when the value of exports exceeds that of imports, indicating
the nation is a net exporter. Conversely, a trade deficit occurs when import values are
greater than exports as the economy relies more on foreign goods, making it a net
importer. The BOT impacts the supply and demand of a nation’s currency in forex
markets, consequently influencing exchange rates.
For instance, heavy exporters like China and Germany build up foreign demand for
their currencies as overseas importers need domestic currency to pay them. This
appreciation pressure gets balanced by the country’s own import demand for foreign

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currencies like the US Dollar. A worsening trade deficit for an economy has the opposite
effect of dampening foreign currency demand while stoking demand for imports, causing
net depreciation pressure on the currency (Madura, 2018).
BOT dynamics depend on factors like trade policies, relative inflation, savings and
investment rates, consumer preferences, and competitiveness - explaining divergences
between economies. Structure of trade in commodities, manufacturing goods and services
also impacts BOT across countries. Over long periods, unsustainable deficits or surpluses
are restrained through automatic adjustments in currency values and trade flows toward
equilibrium per economic theory (Madura, 2018).
But global imbalances may persist for years reflecting policy distortions or
economic conditions, requiring eventual adjustment. Understanding BOT provides
insights for forecasting currency movements, though it is just one of many determinants
of forex supply and demand. Nonetheless, nations monitor BOT closely as chronic
deficits may signal declining economic competitiveness while surpluses indicate export
strength.
3.2. Nominal Exchange Rate
The nominal exchange rate refers to the official rate at which a country's currency
exchanges for another currency in the foreign exchange spot market (Madura, 2018). It is
the rate that is most visible in financial quotes and reports tracking currency trading. For
example, a nominal USD/EUR rate of 1.05 indicates that 1 Euro can be exchanged for
1.05 US Dollars, or vice versa.
The nominal exchange rate does not account for differences in price levels between
the two economies. It simply states the spot rate for currency conversion. In contrast, the
real exchange rate factors relative prices and inflation into exchange rate calculations to
enable purchasing power parity comparisons across currencies.
Nominal rates fluctuate regularly based on forex market dynamics of supply and
demand for currencies influenced by myriad macroeconomic factors. These include
relative inflation rates interest rate differentials, economic growth prospects driving
investment flows, trade balances impacting currency demand, and monetary policy

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actions by central banks (Madura, 2018). Speculation and expectations about future
currency movements also impact daily trading.
Monitoring nominal exchange rates helps businesses and investors track the
changing price of foreign currencies to assist financial decisions involving imports,
exports, repatriating profits, or overseas investments. As exchange rates fluctuate
substantially over days or months, they impose exchange rate risk that must be managed.
Governments also closely follow movements in benchmark currency pairs that impact
export competitiveness and generate currency mismatches with their foreign-denominated
debt obligations.
Over long run time horizons, nominal rates may converge toward purchasing
power parity levels as per macroeconomic theory. But owing to market volatility, nominal
rates often substantially overshoot or undershoot such equilibrium real exchange rate
benchmarks for sustained periods.
3.3. Real Exchange Rate
The real exchange rate adjusts the nominal exchange rate based on relative price
levels between two economies to enable effective comparisons of purchasing power
across currencies (Madura, 2018). It calculates the rate at which goods and services in one
country can be traded for goods and services in another country, after accounting for price
level differences.
For example, if a pack of gum costs $1 in the US and £0.50 in Britain, the nominal
USD/GBP exchange rate is $2 per British Pound. However, the gum actually costs twice
as much in the US. The real exchange rate conversion factors this relative price difference
to compare purchasing powers across the currencies.
The real exchange rate provides a benchmark for assessing if currencies are
over/undervalued relative to economic fundamentals. As per the theory of purchasing
power parity (PPP), exchange rates should evolve to equalize the prices of similar baskets
of goods and services across countries over the long run (Madura, 2018). Real exchange
rates indicating substantial deviations from PPP signal currency misalignments in forex
markets that should reverse toward equilibrium over time.

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 However, real exchange rates derived using broad price indices may not reflect
transactional rates for traded goods best. Also, persistent deviations from PPP occur in
practice owing to transportation costs, official trade barriers, consumer preferences bias
toward local or imported goods, and differential productivity growth rates between
economies. Nonetheless, the concept of real exchange rates remains useful for economists
and policymakers in gauging currency over/under valuations.
Multinational firms may also adjust financial performance measures like profits
earned abroad using real exchange rates to assess foreign market competitiveness
excluding currency fluctuations. But daily forex trading still occurs using nominal spot
rates based on market supply and demand.
4. Distinguish between devaluation and depreciation of domestic currency.
4.1 Devaluation of Currency
Currency devaluation refers to a deliberate downward adjustment of the value of a
country’s currency relative to major benchmark currencies such as the US dollar
(Cavusoglu, 2010). It involves the nation’s monetary authority or central bank officially
resetting exchange rates lower through their market operations and communications
versus allowing market forces to determine currency values.
Devaluations aim to spur economic growth by boosting export competitiveness and
discouraging costly imports (Cavusoglu, 2010). With devalued currency, domestic export
goods become cheaper for foreign buyers, increasing demand abroad. Imports into the
local economy become more expensive due to the higher currency price, reducing
inbound shipments. The stimulative impacts depend on trade elasticities. Fiscal and
political stability factors also determine effectiveness.
Historically, developing economies often devalued currencies to gain trade
advantages. But currency wars remain controversial as trading partners may retaliate by
devaluing their own currencies to neutralize the impact. Devaluations also risk capital
flight and inflationary effects if not implemented prudently with supportive policies. But
controlled devaluations can boost economic growth if administered judiciously.
4.2 Depreciation of Currency

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 In contrast to an official policy action like devaluation, currency depreciation
occurs when market dynamics cause the exchange rate to decline in the absence of
deliberate central bank intervention (Cavusoglu, 2010). The currency becomes cheaper
relative to foreign currencies owing to natural demand and supply factors.
For instance, lower interest rates may trigger capital outflows to seek higher
foreign returns, raising supply of the domestic currency. Weaker economic growth could
dampen foreign investment inflows, hurting demand for the local currency. Rising
inflation can also have a depreciating impact. Currency speculation and deteriorating
public finances are other drivers.
Depreciation, much like devaluation, benefits export competitiveness and growth.
But the risks include higher imported inflation, external debt servicing costs, and foreign
investor confidence plunging. Manageable depreciation corrections aligning overvalued
currencies with fundamentals may aid economic rebalancing. But excessive volatility
from extreme depreciation generally harms growth.
5. How can the State Bank of Vietnam help in bringing down the foreign exchange
rate which is very high?
The State Bank of Vietnam (SBV) is endowed with various monetary policy tools
and forex market intervention capabilities to influence currency exchange rates when
needed to maintain economic stability. With Vietnam's currency, the dong (VND),
appreciating sharply versus the US dollar recently, here are some key measures the SBV
can implement to bring down the very high exchange rate:
5.1. Tightening Monetary Policy
As rising inflation often boosts currency values, the SBV could tighten monetary
policy by raising benchmark interest rates, increasing reserve requirement ratios for
banks, or draining excess liquidity from the financial system (Vo & Phan, 2022). Higher
interest rates increase foreign capital inflows seeking Vietnamese investments with
attractive yields. This rises demand for VND while increasing USD supply, causing the
VND/USD rate to decline over time. However, upside risks of slowing economic growth
exist.
5.2. Selling Foreign Currency Reserves

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 With ample dollar reserves owing to sustained trade surpluses, SBV could conduct
foreign exchange interventions by selling USD reserves to meet local forex market
demand (Vo & Phan, 2022). This directly increases supply of dollars while mopping up
excess VND liquidity. Over time, enlarged USD supply versus stable demand should
moderate the VND exchange rate. This intervention also signals SBV's determination to
resist excessive appreciation pressure on VND.
5.3. Widening the Trading Band
SBV currently allows VND to trade within a tightly managed band of +/- 3%
around the central rate versus the dollar (IMF, 2022). Temporarily widening this trading
band provides more room for managed, two-way movement in the local currency.
Allowing slight incremental depreciation could stem near-term overvaluation risks better
than abrupt future corrections. However, band widening may increase volatility and risks
for exposed sectors. Clear communications on purpose and duration are vital.
5.4. Signaling Future Policy Intentions
Since currency markets front-run based on expected central bank actions, SBV
could use forward guidance and verbal communications to clearly signal intentions for
modest future VND depreciation over its strong valuation concerns (Vo & Phan 2022).
Shaping trader expectations that some gradual depreciation shall be permitted could stem
excessive near-term appreciation bets on the currency better than sudden reactive moves
later.
To summarize, SBV should first utilize measured interest rate hikes and liquidity
absorption to tighten local monetary conditions. Allowing slight downward adjustment in
VND over time is preferable to unsustainable appreciation culminating in an abrupt crash.
Selling USD reserves can provide another policy lever if incremental depreciation fails to
stem overvaluation pressures adequately. Finally, shaping trader perceptions is key
alongside actual interventions to smooth exchange rate normalization.

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 Conclusion
In conclusion, exchange rates constitute a vital cog in the machinery of the global
economic system - enabling international trade, financial flows and globalization critical
for prosperity. As elucidated, an exchange rate is the price of one currency in terms of
another currency that fluctuates based on forex market dynamics of demand and supply.
Myriad macroeconomic factors influence currency demand-supply interplay including
trade and capital flows, inflation and interest rate differentials, speculation, and central
bank policies.
Understanding exchange rate determination has become more imperative than ever
amid deepening global integration. Currency movements impact export competitiveness,
foreign investment returns, import costs and outgoing remittances materially -
necessitating prudent macroeconomic management for stability. Persistently overvalued
or undervalued currencies also require eventual correction to align with economic
fundamentals over long run.
While unfettered currency fluctuations based purely on market forces may aid
timely adjustments, excessive volatility usually hampers trade and growth. Hence most
major economies including China, Japan and the EU intervene actively in forex markets
to smooth overshoots. For emerging markets like Vietnam, managing exchange rates is
even more critical to avoid imported inflation risks, loss of external price competitiveness,
or foreign investor confidence plunging from currency gyrations stoking economic
instability.
As analyzed, Vietnam's central bank has actively deployed interest rate hikes and
dollar sales interventions this year to curb excessive appreciation of the Vietnamese dong.
Further calibrated tightening of monetary policy, allowing modest incremental
depreciation, temporary foreign exchange trading band expansion and shaping trader
expectations through policy signaling are key next steps.
In an increasingly financially integrated world, no nation remains insulated from
global currency dynamics or shocks like the 2023 dollar spikes. Hence vigilance over
exchange rate stability must persist while retaining policy space for temporary
interventions when market overreactions threaten to unhinge trade and growth. Ultimately

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prudent macro-financial governance and policies that align currencies with economic
fundamentals will enable globalization to keep delivering widespread dividends.
To summarize, this essay spotlighted the pivotal influence of currency exchange
rates on cross-border economics - delving into forex market dynamics of demand, supply
and determination while contrasting concepts like nominal-real exchange rates,
devaluations versus depreciation and contemporary contexts like Vietnam's policy
options. As global citizens, businesses and governments navigate the complex world of
international finance and trade, comprehending multifaceted exchange rate dimensions
remains essential.

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