Skip to main content

Factors that Influence Exchange Rates

Aside from factors such as "interest rates" and "inflation", the "exchange rate"  is one of the most significant determinants of a country's relative level of  economic health. It play a vital role in a country's level of trade, which is  critical to most every free market economy in the world.
Major Forces Behind Exchange Rate Movements:
A higher currency makes a country's exports more expensive and imports cheaper  in foreign markets; a lower currency makes a country's exports cheaper and its  imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country's balance of trade, while a lower exchange rate  would increase it.
Determinants of Exchange Rates: Exchange rates are relative, and are expressed as a comparison of the currencies of two countries.
(i) Inflation: As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates.
(ii) Interest Rates: By manipulating interest rates, Central Banks exert  influence over both inflation and exchange rates, and changing interest rates  impact inflation and currency values. Therefore, higher interest rates attract  foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates.
(iii) Deficits of Current Account: The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.
(iv) Public Debt: Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real currency in the future.
In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate.
(v) Terms of Trade: A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value).
(vi) Political Stability and Economic Performance: Political turmoil can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.
Inference: The exchange rate of the currency in which a portfolio holds the bulk of its investments determines that portfolio's real return. A declining exchange rate obviously decreases the purchasing power of income and capital gains derived from any returns. Moreover, the exchange rate influences other income factors such as interest rates, inflation and even capital gains from domestic securities.

Comments

Popular posts from this blog

A very heart Touching Lines from the Movie udaan

जो लहरों से आगे नज़र देख पाती तो तुम जान लेते मैं क्या सोचता हूँ वो आवाज़ तुमको भी जो भेद जाती तो तुम जान लेते मैं क्या सोचता हूँ जिद का तुम्हारे जो पर्दा सरकता तो खिडकियों से आगे भी तुम देख पाते आँखों से आदतों की जो पलकें हटाते तो तुम जान लेते मैं क्या सोचता हूँ मेरी तरह खुद पर होता ज़रा भरोसा तो कुछ दूर तुम भी साथ-साथ आते रंग मेरी आँखों का बांटते ज़रा सा तो कुछ दूर तुम भी साथ-साथ आते नशा आसमान का जो चूमता तुम्हें भी, हसरतें तुम्हारी नया जन्म पातीं खुद दुसरे जनम में मेरी उड़ान छूने कुछ दूर तुम भी साथ-साथ आते

Swami Vivekananda's Speeches (The World Parliament of Religions, Chicago ) Sept 27, 1893

Sisters and Brothers of America, It fills my heart with joy unspeakable to rise in response to the warm and cordial welcome which you have given us. I thank you in the name of the most ancient order of monks in the world; I thank you in the name of the mother of religions, and I thank you in the name of millions and millions of Hindu people of all classes and sects. My thanks, also, to some of the speakers on this platform who, referring to the delegates from the Orient, have told you that these men from far-off nations may well claim the honor of bearing to different lands the idea of toleration. I am proud to belong to a religion which has taught the world both tolerance and universal acceptance. We believe not only in universal toleration, but we accept all religions as true. I am proud to belong to a nation which has sheltered the persecuted and the refugees of all religions and all nations of the earth. I am proud to tell you that we have gathered in our bosom the pure...

Triggering of Force Majeure? COVID-19.

Will COVID-19 trigger Force Majeure? I got this question in the last couple of days from a few of my friends, colleagues and ex-colleagues. I would say there cannot be a straight answer in YES or NO. The answer to the triggering or applicability of Force Majeure lies in what manner and/or circumstances the force majeure clause of an agreement has been drafted. Let’s understand this in detail. Force Majeure and vis-Major (i.e. act of god) are the part of  inevitable accidents . Inevitable accidents are defined, as any accidents that could not have been foreseen or prevented by due care and diligence of any human being involved in it, or which could not by any possibility is prevented from happening by the exercise of ordinary care, caution and skill. Force Majeure means “superior force”  which include  war, riots, explosions or other disasters, energy blackouts, unexpected legislation, lockouts, slowdowns, and strikes, epidemic or pandemic diseases, other specified ...