The exchange rate is one of the most important determinants of a country's relative level of economic health. Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched analyzed and governmentally manipulated economic measures. Before going to forces I would like to post some important things about exchange rates….
Pegging
If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand.
Pegging is a method of fixing a country's currency to stay at a certain rate below or above another country's currency.
A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold.
Uncovered interest rate parity
Uncovered interest rate parity (UIRP) states that an appreciation or depreciation of one currency against another currency might be neutralized by a change in the interest rate differential.
If US interest rates exceed Japanese interest rates then the US dollar should depreciate against the Japanese yen by an amount that prevents arbitrage.
UIRP showed no proof of working after 1990s. Contrary to the theory, currencies with high interest rates characteristically appreciated rather than depreciated on the reward of the containment of inflation and a higher-yielding currency.
Determinants of Exchange Rates
Numerous factors determine exchange rates, and all are related to the trading relationship between two countries. Remember, exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries.
1. Differentials in inflation:
As a rule of thumb, 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.
2. Differentials in interest rates:
Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. 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.
3. Current-account deficits:
The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries. 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.
4. 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. 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.
5. 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). If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners.
6. Political stability and economic performance:
Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.
Sources…
Wikipedia.com
Investopedia.com
Google.com
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