Internal exchange rate

In our globalized 21st century, great price disparities still survive within the same economy: internal 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 rates, 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 in the same country. As a consequence, internal rates influence issues as fundamental to an economy as the purchasing power of its citizens (it is important to remember that when talking about price levels, wages are also included, since they constitute the price of the labor factor), competitiveness of its exports or its ability to attract foreign investors.

As we have commented previously, internal exchange rates can vary from one region to another in the same country, but perhaps the clearest example of this disparity is the eurozone.. 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 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 quotation of currencies, and that in a fully integrated market (also assuming perfect information) the disparities in prices and wages would tend to disappear. The reality, however, becomes much more complex when we analyze it in light of the data.

As can be seen in the graph, the introduction of the euro has only resulted in a convergence of prices in a group of countries (Belgium, Holland, France, Germany, Austria and Ireland) but it does not seem to have affected Spain, Italy in the same way , Finland and Greece. The first conclusion that we can draw from the data, therefore, is that the adoption of a common currency does not by itself guarantee convergence in the price level , that is, that the persistence of these differences despite having eliminated the rates external exchange rate demonstrates the existence of other internal types and completely different characteristics.

The adoption of a common currency does not by itself guarantee price convergence

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 these are countries with a high degree of interdependence . The clearest case of this mutual dependence is that of Belgium and the Netherlands, whose price divergence 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 leads to almost complete price convergence .

This is not the case in the most peripheral economies of the euro area, which seem to have experienced a certain convergence only in the first years of the euro’s existence, only 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 such as Italy and Spain there are notable differences. Taking into account that the degree of interdependence between peripheral economies is much lower than between central ones, we could conclude that this is one of the factors that explains the existence of internal exchange rates.

This explanation is perfectly aligned with what is defended by economic theory: If two economies with different price levels form a single market (that is, with freedom of movement of people, capital and goods) and there is perfect information, the market agents of the country with higher prices will seek to source from the other to reduce your production costs and increase your profit margins. In this way, the country with the lowest prices would benefit from an increase in exports and the inflow of foreign capital for investment. These factors would generate inflationary pressures, which, added to the deflationary trend of the neighboring country (which would be suffering the opposite effect, that is, flight of capital and fall in national production to the detriment of imports).) would lead to price convergence, thus fulfilling the maxim that the market unit supposes a single price .

However, it should be noted that interdependence, while undoubtedly a decisive factor in understanding domestic exchange rates, is not a sufficient explanation either. If this were the case, prices in Spain would end up equal to those of France since the Hispanic economy would benefit from the relocation of French production and an increase in exports to the French country. On the other hand, the empirical evidence tells us that the divergence in prices has hardly altered since 2002, which is still natural if we consider the differences between the two countries in terms of the added value of their economies.. Quite simply, this occurs because the productive sectors that generate more value compensate their employees with better salaries and sell their products at higher prices, leading to a higher internal exchange rate as well.

Finally, we also find a factor no less important in the particularities of national economies . In this sense, the existence of differences in the fiscal framework and in labor regulation, or the implementation of national price policies (whether inflationary or internal devaluation) can slow down the convergence between interdependent economies that generate added value. Similary.

The existence of internal rates (which, as we have already mentioned, do not only occur on a national scale but also on a regional or local scale) usually has a strong impact on the economies of the countries. On the one hand, it increases the relative purchasing power of countries with high rates , since it allows them to buy, invest or go tourism in those with lower rates at more competitive prices. However, sometimes they can also be harmed, since their national economy can suffer a certain dumping  from the foreign supply. On the contrary, countries with low interest rates can reinforce their growth economic thanks to the foreign sector, but their capacities will be reduced when going abroad.

In this sense, it is important to remember the differentiating role of added value , since the countries that have opted in this way have managed to maintain a better level of wages without falling at risk of dumping or destroying jobs. On the contrary, many of the countries that have opted for competitiveness through costs have been forced to boost their exports with internal devaluation policies, entering a vicious circle that can translate into lower wages and purchasing power, lower savings and the increase in debt and foreign dependence. In other words, changes in domestic exchange rates can have positive effects on the economy if they reflect the evolution of value.of actual production, but can be a source of serious imbalances if artificially manipulated.

In conclusion, we can say that domestic 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 can be responsible for serious structural imbalances if they are fixed artificially. However, they can also give rise 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 price convergence. This is perhaps the true paradox of internal exchange rates: unlike other growth factors, internal rates can be very beneficial for the economy, but only to the extent that they can disappear.