Question

How the Rate of Exchange is determined? Illustrate.

Answer 1

Determinants of Exchange Rates:
Exchange rates are determined by numerous factors and they are related to the trading relationship between two countries.
Factors determining Exchange Rate:

1. Differentials in Inflation
2. Differentials in Interest Rates
3. Current Account Deficits
4. Public Debt
5. Terms of Trade
6. Political and Economic Stability
7. Recession
8. Speculation

1. Differentials in Inflation:

1. Inflation and exchange rates are inversely related.
2. A country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies

2. Differentials in Interest Rates:

1. There is a high degree of correlation between interest rates, inflation, and exchange rates.
2. Central banks can influence both inflation and exchange rates by manipulating interest rates.
3. Higher interest rates attract foreign capital and cause the exchange rate to rising and vice versa.

3. Current Account Deficits:

1. A deficit in the current account implies an excess payment over receipts.
2. The country resorts to borrowing capital from foreign sources to make up the deficit.
3. Excess demand for foreign currency lowers a country’s exchange rate.

4. Public Debt:

1. Large public debts are driving out foreign investors because it leads to inflation.
2. As a result, the exchange rate will be lower.

5. Terms of Trade:

1. A country’s terms of trade also determine the exchange rate.
2. If the price of a country’s exports rises by a greater rate than that of its imports, its terms ‘ of trade will improve.
3. Favorable terms of trade imply greater demand for the country’s exports and thus BoP becomes favorable.

6. Political and Economic Stability:
If a nation’s political climate is stable and economic performance is good, its currency value will be appreciated by attracting more foreign capital.

7. Recession:

1. Interest rates are low during the recession phase.
2. This will decrease the inflow of foreign capital.
3. As a result, a currency will be depreciated against other currencies, thereby lowering the exchange rate.

8. Speculation:

1. If a country’s currency value is expected to rise, investors will demand more of that currency in order to make a profit in the near future.
2. This results in appreciation of the exchange rate.
3. Besides the above determinants, relative dominance in global politics and the power to announce economic sanctions over other countries also determine exchange rates.