Determinants of Exchange rate

THEORIES OF EXCHANGE RATES

Exchange rate is one of the determinants of the economic health of the economy Others
are the inflation! interest rate and gro"th Exchange rates #lay an im#ortant role in the
le$el of trade of the co%ntry! "hich is critical to most free mar&et economies in the "orld
For this reason! exchange rate is the most "atched! analy'ed and go$ernmentally
mani#%lated economic meas%re (e sho%ld try to %nderstand ho" exchange rate
mo$ements affect a nation)s trading relationshi#s "ith other nations A higher $al%e of
R%#ee in terms of * ma&es a co%ntry)s ex#orts more ex#ensi$e and im#orts chea#er in
foreign mar&ets+ a lo"er c%rrency ma&es a co%ntry)s ex#orts chea#er and its im#orts
more ex#ensi$e in foreign mar&ets A higher exchange rate can ,e ex#ected to lo"er the
co%ntry)s ,alance of trade! "hile a lo"er exchange rate "o%ld increase it
The exchange rate ,et"een t"o c%rrencies is determined ,y the s%##ly and demand for
those t"o c%rrencies The s%##ly and demand for c%rrencies on the international mar&ets
is determined ,y the ,%ying #o"er of the c%rrencies
The law of demand a##lies to foreign c%rrencies -emand for .S * increases "hen the
#rice of * in terms of r%#ees falls and $ice $ersa
Factors/
Demand for Foreign exchange/ 0 im#orts! 0 ca#ital o%tflo"! 0 ex#ectations
1s#ec%lation2! 0 relati$e #rices! 0 income! 0 exchange rate! 0 exogeno%s 3 endogeno%s
factors! 0 go$t #olicies 1tariff! im#ort controls2
Supply of Foreign exchange: 0 ex#orts! 0 inflo" of ca#ital! 0 com#etiti$eness! 0 go$t
#olicies! 0 exogeno%s 3 endogeno%s factors
Supply of Dollars
The s%##ly of dollars is the 4%antity
S%##ly is determined ,y the action of the go$ernment and the Central 5an& of dollar
assets a$aila,le for the #eo#le to hold.
For exam#le! in a fixed exchange rate system s%##ly is infinite at the rate of exchange is
-ecided ,y the go$t and I6F A hori'ontal line
-ro%ghts! good rainfalls! ne" reso%rce findings increase dollars
DETERMI!TI" "F E#$%!&E R!TE
Firms
&o't.
%ouseholds
Financial
mar(et
Imports )M* exports )#*
Factor
Mar(et
+roduct
mar(et
Foreign Mar(et
,
Rs.-
,
-
S
et capital
inflow
In a flexi,le exchange rate system 1,2 the 4%antity of .S dollars is fixed so that the
s%##ly c%r$e is $ertical The increase in the demand for .S * from -7 to -8 res%lts in an
increase in the $al%e of * 1decrease in the $al%e of R%#ee2 In the managed exchange
rate system! 1c2 the central ,an& has an %#"ard9slo#ing s%##ly c%r$e of * If demand
increases from -7 to -8 the * a##reciates ,%t the 4%antity of * also increases 1the $al%e
of r%#ee de#reciate not at the le$el in 1,2
"ther factors that ha'e impact on the 'alue of the exchange rate are:
.. Differentials in inflation: a co%ntry "ith a consistently lo"er inflation rate
exhi,its a rising c%rrency $al%e! as its #%rchasing #o"er increases relati$e to other
c%rrencies -%ring the last half of the t"entieth cent%ry! the co%ntries "ith lo"
inflation incl%ded :a#an! Germany and S"it'erland! "hile the .S and Canada
achie$ed lo" inflation only later Those co%ntries "ith higher inflation ty#ically
see de#reciation in their c%rrency in relation to the c%rrencies of their trading
#artners This is also %s%ally accom#anied ,y higher interest rates
/. Differentials in interest rates: Interest rates! inflation and exchange rates are all
highly correlated 5y mani#%lating interest rates! central ,an&s exert infl%ence
o$er ,oth inflation and exchange rates! and changing interest rates im#act
inflation and c%rrency $al%es Higher interest rates offer sa$ers in an economy a
higher ret%rn relati$e to other co%ntries Therefore! higher interest rates attract
foreign ca#ital and ca%se the exchange rate to rise The o##osite relationshi#
exists for decreasing interest rates 9 that is! lo"er interest rates tend to decrease
exchange rates
0. $urrent1account deficits: The c%rrent acco%nt is the ,alance of trade ,et"een
co%ntries for goods! ser$ices! interest and di$idends A deficit in the c%rrent
acco%nt sho"s the co%ntry is s#ending more on foreign trade than it is earning!
2uantity
),*
Rs per
),*
Rs.34-, .
Rs.33-, .
Rs..3-, .
Rs..4-, .
2uantity
),*
Rs per
),*
Rs.34-, .
Rs.33-, .
Rs..3-, .
Rs..4-, .
2uantity
),*
Rs per
),*
Rs.34-, .
Rs.33-, .
Rs..3-, .
Rs..4-, .
S
D3 D.
S
D3
D.
D3
S
D.
)a* Fixed Exchange rate )5* Flexi5le Exchange rate 6 Managed Exchange rate
23
23 2.
23 2.
Rs..0-, .
and that it is ,orro"ing ca#ital from foreign so%rces to ma&e %# the deficit In
other "ords! the co%ntry re4%ires more foreign c%rrency than it recei$es thro%gh
sales of ex#orts The excess demand for foreign c%rrency lo"ers the co%ntry)s
exchange rate %ntil domestic goods and ser$ices are chea# eno%gh for foreigners!
and foreign assets are too ex#ensi$e to generate sales for domestic interests
7. +u5lic de5t: go$ernments engage in large9scale deficit financing to #ay for
#%,lic sector #ro;ects and go$ernmental f%nding (hile s%ch acti$ity stim%lates
the domestic economy! nations "ith large #%,lic deficits and de,ts are less
attracti$e to foreign in$estors The reason? A large debt encourages inflation,
and if inflation is high, the debt will be serviced and ultimately paid off with
cheaper real dollars in the future.
Sometimes! the go$ernment may #rint money to #ay #art of a large de,t! ,%t
increasing the money s%##ly ine$ita,ly ca%ses inflation Moreover, if a
government is not able to service its deficit through domestic means (selling
domestic bonds, increasing the money supply), then it must increase the supply
of securities for sale to foreigners, thereby lowering their prices. Finally, a
large debt may prove worrisome to foreigners if they believe the country risks
defaulting on its obligations. Foreigners will be less willing to own securities
denominated in that currency if the risk of default is great. For this reason, the
country's debt rating (as determined by Moody's or Standard !oor's, for
e"ample) is a crucial determinant of its e"change rate.
4. Terms of trade: A ratio com#aring ex#ort #rices to im#ort #rices! the terms of
trade is related to c%rrent acco%nts and the ,alance of #ayments If the #rice of a
co%ntry)s ex#orts rises ,y a greater rate than that of its im#orts! its terms of trade
ha$e fa$ora,ly im#ro$ed Increasing terms of trade sho"s greater demand for the
co%ntry)s ex#orts This! in t%rn! res%lts in rising re$en%es from ex#orts! "hich
#ro$ides increased demand for the co%ntry)s c%rrency 1and an increase in the
c%rrency)s $al%e2 If the #rice of ex#orts rises ,y a smaller rate than that of its
im#orts! the c%rrency)s $al%e "ill decrease in relation to its trading #artners
8. +olitical sta5ility and economic performance: Foreign in$estors ine$ita,ly
see& o%t sta,le co%ntries "ith strong economic #erformance in "hich to in$est
their ca#ital A co%ntry "ith s%ch #ositi$e attri,%tes "ill dra" in$estment f%nds
a"ay from other co%ntries <olitical chaos can ca%se a loss of confidence in a
c%rrency and a mo$ement of ca#ital to the c%rrencies of more sta,le co%ntries