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Forex: Reasons for Imbalances

A principal reason for changes in monetary values between countries is disproportionate differences in internal inflation rates that result in price differentials. In turn, the price differentials result in changes in the flow of goods, services, and capital between countries, which brings about the monetary changes.

As prices rise faster in one country than another, imports and exports are affected in both.

Internally, inflationary changes are reflected by economic indicators, such as cost-of-living indices; externally, they are reflected by the change in value of one currency vis--vis another. The monetary system that evolved from the Bretton Woods agreement was based on the assumption that governments will take the action necessary to control their domestic situations and thereby keep the relationships of their currencies within the agreed-upon limits.

Unfortunately, practical politics often preclude or delay necessary fiscal action. The result is that relationships between currencies, the matter of parity, can do and get out of balance and force a devaluation or revaluation. That also has to be taken into account by the businessman who operates in more than one country.

To some extent, values in one country as determined by the fluctuations of the currency of another country are a measure of internal changes. For that reason, many of the foreign exchange measures for protecting against changes in currency value are also useful to the businessman who operates in only one country and must so manage his business as to cope with the effects on internal inflation.

Valuations in otherurrencies do identify problems more clearly, but the same identification could be made by using a local currency index and determining the effect of internal price changes.

For the present purposes, it is pertinent to discuss what happens when a business operates in two or more countries that have different currencies. In order to evaluate operating results, a common denominator must be used; it is usually the currency of the country in which the business is principally located or that in which it is incorporated.

By the use of a common denominator, one currency is evaluated in terms of another, and that at once gives rise to problems in foreign exchange. In order to operate in business in several countries, managers must deal with transactions in other currencies and adopt policies and strategies that will maximize their return in relation to whatever standards they adopt.

All the aspects of a business--- its structure and nature, the countries in which it operates, its products and its goals--- have an influence on the relative importance of the various factors involved in foreign exchange decisions.

Once it appears that a proper opportunity exists in relation to the potential of the market, the resources available, and the risk, then how to manage any foreign exchange problems can, and should be worked out.

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