An Examination of the Main Influences on the Exchange Rate of a Currency

Categories: Currency

What are the Main Influences on Exchange Rate of a Currency?Currency exchange rate is an important factor for consideration in determining theeconomic growth of a country. Exchange rates play a critical role in a country’s level of trade asit affects how a country trades with other nations.

A higher currency exchange rate makes exportsmore expensive and imports cheaper in the foreign market thus it lowers the country’s balance oftrade. On the other hand, lower exchange rate makes a country’s export cheaper and importsexpensive and this increases the balance of trade.

Exchange rates are usually relative, and so theyare expressed in relation to currencies of two countries.

The exchange rates are affected byfundamental economic forces and market sentiments as discussed below.Difference in inflation. – Inflation is the general rise in prices of goods and services. Acountry that maintains low inflation rate usually experiences an increase in currency value. Moreover, currencies of countries with higher inflation depreciate relative to those of theirtrading partners.

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If the rate of inflation in a Eurozone country is lower than countries that useother forms of currencies, there will be increased demand for euros to buy goods from thiscountry. (Chung et. Al. 2011)Deficit in current accounts- the current account is the balance of trade between twocountries that includes all the payments between the two countries for goods, services, interestsand dividends.

When a country has a deficit in its current account, it means it is spending moreon foreign trade than its earning. To make up for the deficit, it means that it has to borrow capitalfrom foreign sources.

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Its exports are generating less foreign currency to meet its requirements,thus the excess demand for foreign currency will push the country’s exchange rate until domesticgoods, and services are affordable to foreigners.

Difference in interest rates- central banks through the monetary policy manipulatesinterest rates thus directly affecting inflation and hence the exchange rates. When they increasethe interest rates, foreign investors (lenders) are attracted to the country because they expecthigher returns when compared to other countries.

When interest rates are decreased, they do notattract foreign capital, and this leads to a decrease in exchange ratesPublic debt of a country- if a country spends more on public sector projects in order to stimulatethe domestic economy may incur large deficits while facilitating these projects.

However, a largedebt leads to inflation because its repayment is at a later date whereby the real value of a eurowill be lower than the value today. This means the debt will be paid off with cheaper real euros inthe future.

Terms of trade- it’s the comparison of a country’s export prices and import prices. If exports of a country sell at higher prices than the imports, the terms of trade are said to befavorable. This means there is bigger demand for the country’s exports and in order to buy themthere is an raise in demand for a country’s currency hence increase in its value. Supposing theprices of exports rise by a smaller rate than that of its imports, the balance of payments becomesunfavorable.

This means there is a drop in demand for a country’s exports, leading to afall in demand for a country’s currency and so does the exchange rate.Political stability. – Foreign investors want to invest their money in politically stablecountries. Countries with stable governments provide a conducive environment for economicgrowth as the investors perceive low political and economic risks.

According to the monetary model which is the earliest model of exchange rate, the currentexchange rate is determined by current fundamental economic variables i.e. money supplies andoutput levels of the country. These fundamentals are combined with market expectations of future rates to give the current rates. Market speculation plays a major role in the determinationof exchange rate of currencies.

Speculators who believe that the euro rise in the near futuretake the risk and start to demand the euro now in order to earn profits the future. This demandcauses rise of exchange rate of the dollar in the present. This change is not caused by theeconomic fundamentals but by positive sentiments of the market. Therefore, if there areexpectations of change in future exchange rates in the financial markets, the current exchangerates will move in the same direction.( Bilson. 1998).

The monetary model has close focus onthe demand and supply of money. If the money supply in the Eurozone raises, other factors heldconstant the average level of prices in these countries will rise (demand-pull inflation). Assumingthe prices in other countries remain constant, more euros will be needed to buy one unit offoreign currency.

This causes the euro to depreciate in terms of the foreign currency. If the grossdomestic product of a eurozone country rises with the supply of money and other factors heldconstant, the average prices within these countries will tend to fall, and the euro will appreciate.

Several economic theories have been formulated to explain the functioning of foreignexchange rate. Purchasing power parity model is one that estimates how much adjustmentrequires to be made to the exchange rates between two countries so that the exchange isequivalent to each of the currencies purchasing power. This means when this adjustment is madethe price of an identical product in the two countries is the same when expressed in the samecurrency.

Purchasing power parity is a relative figure given by the formula:E = p1/p2Whereis the is the exchange rate of currency 1 to currency 2P1 is the cost of product x in country 1. P2 is the cost of product x in currency 2For example, if a bottle of wine costs 10 euros in France and 15 dollars in United States, theexchange rate between the dollar and the euro is 1.5 EUR/USD.Supposing one euro (EUR) sells for 10 Swedish krona (SEK).

A skating board in Francecosts 40 euros and 150 Swedish krona. With the exchange rate 1EUR= 10SEK, then buying theskating board from Sweden will cost 15EUR. It is more economical to buy the skating board inSweden, and any rational consumer would do that. If they do this, we expect that Frenchconsumers will sell the euro and buy Swedish krona, and this increases the demand of the krona.

The demand for the skating boards sold in France decreases and this forces French retailers tolower their prices. The demand for skating boards sold in Sweden increases push the pricesupwards, and this is expected to continue until purchasing power parity is achieved. The eurodeclines in value to 1EUR=8SEK, the price for skating boards in France goes down to 30 EUR,and the prices in Sweden go up to 240 SEK.

At this point purchasing power parity is achievedsince a consumer is not better off buying from one country.According to Froot and Ragoff (1995), commenting on purchasing power parity theory,the price differentials in the country are not sustainable in the long run because market forceswill harmonize prices between countries and hence alter the exchange rates in so doing.

Theprice difference is not sustainable because individuals or companies will be able to gain arbitrageprofits when they buy the skating boards in Sweden at a lower price and sell them at higherprices in France. The above illustration about the consumers’ crossing over to Sweden to by askating board seems unreasonable given the costs that would be incurred for such a trip but itmakes sense when thousands of them are being imported for sale in France.

Distinguish the different types of foreign exchange regimes that an economy can adoptgiving the advantages and disadvantages of each.Exchange rate regime refers to the way in which a country manages its currency in relation toforeign currencies and the foreign exchange market. The following are the major foreignexchange regimes. (Frankel 2000)Floating exchange rate- it’s also known as the fluctuating exchange rate. This regimeallows a currency’s value to fluctuate in accordance with the foreign exchange markets.Currencies under this regime are known as floating currencies a good example is the UnitedStates dollar, the sterling pound and the euro. This regime is good for countries whose economiesare strong to withstand the constant change in value of the currency.

The advantages of thisregime are numerous and include: the balance of payment adjusts automatically. Any balance ofpayment disequilibrium is adjusted by a change in exchange rate. This means that if a countryhas a balance of payment deficit the currency will depreciate. Another advantage is flexibility ifexchange rates are fixed, and a crisis occurs some economies will collapse because they becomeuncompetitive due to high inflation rate.

A floating rate allows a country to readjust in a flexibleway to external shocks. A country with a floating exchange rate does not need to hold largeamounts of foreign currency because these reserves have an opportunity cost of tying downcapital that could be used for domestic developments.

The disadvantages of this regime include:uncertainty as the value of the of the currency changes from day to day making trade unstable.Sellers are not able to determine what prices they will sell with abroad as the constantly changingrates will affect the price and thus sales. There is a lot of speculation in the floating rate systemand it can destabilize the economy because the speculative flows may differ from the real pattern of trade. Floating exchange rates can cause inflation due to lack of discipline in economicmanagement.

Another foreign exchange regime is the fixed exchange regime whereby the governmentor central bank mediates in the currency markets so that the exchange rates stay close to a setexchange rate target. A country’s government how much its currency is worth in terms of fixedweights on assets, another currency or basket of other currencies.

The country’s central bank willhold reserves of foreign currencies and gold so that it ensures the currency will maintain its fixedvalue. The central bank will be willing to buy and sell its currency at a fixed price at all times.itis through the selling and buying of these reserves that the central bank intervenes when there isexcess demand and supply of the country’s currency in the foreign exchange market.

Advantagesof fixed exchange rate regime include; risk is reduced since the rates are fixed buyers and sellersin international trade can agree or predict prices with certainty, and this helps to encourageinvestment. Secondly, it encourages discipline and sound economic management.

Governmentshave the burden to adjust equilibrium or strain their domestic economy thus they discourage anyinflationary policies which could lead to unemployment and balance of payment disequilibriumthe disadvantages of this regime are; it requires a government to hold large reserves of foreigncurrencies to maintain the fixed rates. These reserves if converted to domestic currency could beused for development projects or investment thus there is an opportunity cost effect.

Another disadvantage is that countries with a fixed exchange regime lose freedom over internal policy.Needs for exchange rate are given priority since the government is obligated. It sets interest ratesand other policies based on exchange rates while ignoring other important macroeconomicfactors like inflation and unemployment.

Pegged exchange rate regime is another regime adopted by developing and communisteconomies. Pegged currencies are pegged to some band or value that is either fixed or adjustedperiodically. This regime has characteristics of both fixed and floating regime. There are threetypes of pegged regime namely crawling bands, crawling pegs and pegs with horizontal bands. For the purpose of export and trade, a developing country can peg its currency to a strongercurrency to keep its exchange rate low. This supports the competitiveness of goods as they aresold abroad.

Can the adoption of a single currency like the euro offer a solution to managing exchangerate volatility? Yes, the adoption of a single currency helps to manage exchange rate volatility to someextent. Exchange rate volatility is the tendency of the foreign currencies to appreciate ordepreciate in value, and this leads to profits or losses in foreign trade.

Volatility measures theamount of change in these rates and how frequently they occur. This discussion will focus on theEurozone that was formed under the Maastricht treaty that was signed in February 1992 thatcreated the European Union and established the euro.

The euro is the common currency used by17 of the 27 member state countries. In the counties that make up the Eurozone, the euro hasreplaced the national currencies, and any new member wishing to join the Eurozone has tomply with adopting the euro after meeting some necessary set criteria. Adoption of a common currency helps to regulate the inflation. For instance Eurozone,under the Maastricht criteria the inflation among member countries remains limited to not morethan 1.5 percent of the three Eurozone member state with the lowest inflation in the previousyear.

Adoption of a common currency also helps in the regulation of interest rates. Interest rate is animportant factor in determining the long-term volatility of foreign exchange market. It is a twoway relationship because interest rates are also affected by the fluctuation resulting fromvolatility and influences the decisions of the central banks. The difference in interest rates increasesthe number of transactions in a market (Taylor, 2001).

Take an example whereby a business in country A that uses foreign currency decides tomake a purchase from a supplier in country B that uses the euro. They agree on a price, but theactual transaction is to occur on a later date. As time passes by the euros, appreciate in value.When the purchasing company converts the foreign currency into euros to acquire the specifiedamount of goods in the contract, it will have to spend more of its money.

It is evident that theexchange rate volatility has affected the purchasing power of the company and potentiallyreduced its profits. In the presence of a common currency, say both countries are using the eurothis would not have been the case. The alternatives that the purchasing company could have usedin the absence of common currency are either converted its money immediately into euros afterentering into the contract, this would predate any possible rate volatility or enter into a futurecontract.

If the company entered into a future contact, it would prevent the exchange ratevolatility but, on the other hand, this would prevent the selling party from benefiting from therates that moved to the advantage. It the purchasing company decided to convert its money toforeign currency they would end up tying up their capital that could be invested in domesticopportunities for the time being.

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An Examination of the Main Influences on the Exchange Rate of a Currency. (2021, Oct 05). Retrieved from

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