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Module Five-Factors Affecting Exchange Rates

There are several key factors that affect exchange rates: 1. Differing rates of inflation between countries - Countries with higher inflation will see currency depreciation while those with lower inflation will see appreciation. This is related to purchasing power parity. 2. Capital movements - Currencies of countries importing capital will appreciate while those exporting capital will depreciate. For example, increased investment in UK would increase demand for pounds. 3. Structural changes in economies that impact comparative advantage can influence exchange rates. 4. Speculation by traders expecting changes in currency values can impact supply and demand and thus exchange rates in the short term.

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57 views

Module Five-Factors Affecting Exchange Rates

There are several key factors that affect exchange rates: 1. Differing rates of inflation between countries - Countries with higher inflation will see currency depreciation while those with lower inflation will see appreciation. This is related to purchasing power parity. 2. Capital movements - Currencies of countries importing capital will appreciate while those exporting capital will depreciate. For example, increased investment in UK would increase demand for pounds. 3. Structural changes in economies that impact comparative advantage can influence exchange rates. 4. Speculation by traders expecting changes in currency values can impact supply and demand and thus exchange rates in the short term.

Uploaded by

Vijai Anand
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Factors Affecting the Exchange Rate

Factor # 1. Differing Rates of Inflation:


True enough, the exchange rates of countries that inflate fastest will be depreciating,
while the exchange rates of countries that inflate slowest will be appreciating. Changes
in relative price levels and exchange rates can exactly offset each other, leaving relative
international competitive position unchanged. This is the essence of purchas­ing power
parity theory.

The logic is simple. With all wages and prices exactly doubled in India (and money
supply doubled to finance them), India can buy exactly the same volume of imports and
sell exactly the same volume of exports at the new exchange rate that has doubled like
everything else. (It is as if each old rupee were now equal to two new rupees.)
Interest And Inflation Rates
Inflation is the rate at which the cost of goods and services rise over time. Interest rates
indicate the amount charged by banks for borrowing money. These two are linked by
the fact that people tend to borrow and spend more when the interest rates are low,
which results in increase in costs. These rates are direct indicators of current and future
economic performance of a country and can influence the decisions of forex investors
and traders through the globe. An increase in interest rate is usually followed by a rise in
the value of the local currency. This happens usually because the economy is growing
too fast and central banks are trying to slow inflation.
Factor # 2. Capital Movements:
Exchange rates are also affected by major capital flows. The currencies of capital-
importing countries usually appreciate and capital-exporting countries experience
depreciation of their currencies.

Suppose American savers wish to buy British assets and thus invest much of their
savings in Britain. An increased desire to invest in the UK will lead to an increase
demand for sterling. The demand curve for sterling will shift to the right. Consequently,
the sterling will appreciate in value and the dollar will depreciate.

Current Account Deficits


The current account is the balance of trade between a country and its trading partners.
It describes the difference in value between the goods and services trades with other
countries. If a country buys more than it sells then the balance of trade is deficit. It
directly affects the exchange rate since a country will need more foreign capital, thus
diminishing the demand for local currency. This excess supply of local currency drives
down its value against foreign currency.
Factor # 3. Structural Changes:
In a dynamic world structural changes like changes in cost structures, or the invention
of new products or any such factor that affects the pattern of comparative advantage,
may and often do affect the exchange rate.
Factor # 4. Role of Speculation:
It may also be noted that exchange rate changes are often caused by the actions of the
speculators. If they expect the price of dollar to go up in terms of sterling they will buy
dollar by selling sterling. The supply of sterling will go up and the supply of dollar will fall
in the foreign exchange market. So dollar will appreciate and sterling will depre­ciate.

In fact, the debate over fixed and floating exchange rates revolves around the role of
speculators. As in stock exchanges and commodities markets, speculators tend to take a
very short view and reinforce price movements in a destabilising manner rather than
counteract them.
Government Debt
This is the total national or public debt owed by the central government. A country with
large amount of government debt is less likely to attract foreign investment and acquire
foreign capital, leading to inflation. It may also happen that existing foreign investors
will sell their bonds in the open market if they foresee an increase in government
debts. This will result in an over supply of the local currency, thus diminishing its value.

Recession:

During a recession, a country’s interest rates are likely to fall, thus decreasing its
chances to acquire foreign capital. This in turn weakens the currency of the country in
question, therefore weakening the exchange rate.

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