Exchange rates refers to the rate at which a particular country’s currency trades against currency belonging to another currency on a foreign exchange market. The rate of currency exchange tends to reflect the position of a particular nation in the background realm of world economy (Stein, & Allen, 2017). Besides, the rate of currency exchange in relation to currencies belonging to other nations reflects the unit price of currency that is beings used and expressed in terms of another currency. Arguably, it expresses the country’s currency of fiscal unit price of the overseas nations.the exchange rate of currencies play a significant role in determining , assessing as well in reassing country’s economy in the world market(Barbosa etal,2018). Notably, exchange rate of currency is considered as apivotal tool not only in connecting economy of a particular Nation with that of the rest of the world but also in transmitting monetary, policy and economic changes.
Usually, the level of exchange rate represents a significant element of credibility of monetary system in a particular nation. Therefore, it is regarded as essential macro-economic factor in the formulation of monetary policy. In addition, any crisis related to currency indicates how exchange rates can significantly impact economic developments of particular Country. Currency crisis may occur as result of excessive external borrowing thus exposing country to foreign exchange risks(Stein, & Allen, 2017). Notably, exchange rates play a crucial role in assessing and reassessing economy of a particular country.it is therefore, considered not only as an essential tool which connects economy of particular country with the rest of the world but also as an important tool for transmitting monetary policy and changes in economy. This paper therefore, seeks to examine determinants of exchange rates.
There are several factors which influence exchange rates including;
Inflation rate is one of the determinant of exchange rates. In this case, any changes in the comparative rate of inflation is likely to impact significantly the global trading activity, thus affecting the demand and supply of currencies and hence, influencing exchange rate of currencies (Georgiadis, 2016).For instance, if the inflation rate of United States of America hikes and that of United Kingdom remain the same, the is high probability that British exports will become more competitive thus resulting to increased demand for british commodities and therefore, the US aggregate demand for the UK currency will increase tremendously. Besides, increase in the inflation rate in US likely reduce demand for US goods in UK.Hence, there is greater need to reduce the supply of pounds available for sale hence putting an upward pressure on the Pound’s value.
Inflation determines currency exchange rates by influencing the level of price changes. In this regard, countries with high inflation rates experience currency devaluation.Basically, high rate of inflation inextricably linked to currency devaluations simply because commodities tend to become more expensive by reducing their demand. Therefore, inflation is strongly connected to exchange exchange rates (Mueller etal,2017). Increase in the inflation rate within a particular country tends to increase exchange rate. This is because inflations tends to increase supply of money within a particular country’s economy and thus, forcing exchange rate of currency to increase.
The figure1: from the figure above, if the inflation rate of US dollar exchange rate increases, the aggregate demand of Mexican dollars currency will also increase tremendously.
In addition, Interest rates is also an important factor that determines exchange rate of currency. Any changes in the comparative interest rate tends to influence significantly investment particularly on foreign securities traded in the stock markets. Changes in the relative interest tends to influence demand and supply of currencies and thus determining exchange rates (Mueller etal,2017). For instance, if United States of America increases its interest rates while the british intrest rates remain the same. In this regard, the aggregate demand for British pounds is likely to decline, simply because the Interest rates in US are more attractive to foreign security investors and therefore, there will be less demand for the British Bank deposits. In this case, the suppy of pound being sold by british investors should be increase in order to establish more bank deposits in US. In most cases, this is perceived as inward shift in the aggregate demand for British pounds and an outward shift in the supply of pounds available for sale and therefore, exchange rate is likely to reduce.Occasionally, changes in the rate of intrest in the developing countries is likely to impact significantly currency exchange rate between two nations. For example, if interest rates in Canada increase, it becomes more attractive to investors from UK when compared to rates in US . in this regard, supply of british pounds to be traded for traders will be lesser thus putting an ascending pressure on the value of pounds compared to US dollar.
Figure 2: Showing relationship between interest rates in UK and United States.
Relative Income levels is another important determinant of exchange rate. The relative income level of particular nation tends to influence the demand of goods or services to be imported thus affecting the exchange rate of currency (Waryati etal,2019). For instance, if income levels in United states of America increase and income levels in Uk remain the Same. This scenario will basically depict three circumstances:i) the aggregate demand for british pounds will outward indicating an increase in the US income levels and there will be increased demand for goods imported from UK., ii) the supply of british pounds available is expected not to change, iii) The exchange rate of british pound currency will increase.
The Balance of payments is also another important economic variable that is likely to influence exchange rate of currency of a particular country. Increase in deficit levels or balance of Payments determin devaluation or depreciation of local currency while on the other hand, decrease in Balance of payments results in the appreciation of local currency (Waryati etal,2019). For instance, the current BOP in US of 7% GDP was the main reason for the depreciation of dollar between the year 2006 and 2007. The balance of payments or deficit level consists of the current and capital account, its impact on the currency exchange rates is intricate but sometimes it is reversed(Barbosa etal,2018). Therefore, trade deficits which generally results to currency depreciation can be recoverd by capital inputs that are like to lead to local currency appreciation.
Figure3: below shows UK trade and current BOP % of GDP
Speculation is another factor that is likely to influence exchange rate of currency. In most cases, speculators tend make profits through margins by trying to buy and sell currencies. For example, if speculators believe that price of pound wil rise in the near future, they will make effort to acquire more now in r to make more profit in the future. Increase in demand for british pound will make its value to appreciate (Li, X., & Wang, 2017). It is imperative to understand that shift in the exchange rate is not always determined by the fundamentals of economy but by financial market sentiments.
Changes in competitiveness is another important factor that is likely to influence exchange rate. Increase in the competitiveness of global markets tends to increase the long-run of currency value. For instance, if UK goods and services become more more striking and competitive this will definitely make the value of currency exchange rate to increase.
In addition,the strength of other currencies is another factor that is likely to influence significantly the exchange rate and perceived to have vice-versa effect (Barbosa etal,2018). For instance, the value of pound appreciated between the year 1999 and 2001 since Euro was perced as a scrawny currency. Weak currency tends to provide plenty of benefits boosting the economy of country by increasing exports thus increasing the competitiveness of nation’s goods thus, increasing the aggregate foreign demand while at the sametime maintaining the demand of local consumers. These benefits accruing from sale of exports leads to creation of more employment opportunities, increasing consumer spending power and well as help in reducing country’s trade deficits(Chen etal,2016). Also, weak currency leads to increase in foreign investments and increase in tourism activities which generate more revenues for the country and also in creating job opportunities.
Productivity is another factor that is likely to influence exchange rate of currency. If a specific nation is more productive than other countries, there is a high likelihood that the prices of commodities will be more cheaper than prices of goods imported (Chen etal,2016). As a concequence, the aggregate demand for local goods will increase and currency will be overdeemed. The reduction of local goods prices in the country will result to increase in exports thus causing currency evaluation.
In conclusion, exchange rates refers to the rate at which a particular country’s currency trades against currency belonging to another currency on a foreign exchange market. The rate of currency exchange tends to reflect the position of a particular nation in the background realm of world economy. In addition, the rate of currency exchange in relation to currencies belonging to other nations reflects the unit price of currency that is beings used and expressed in terms of another currency. There are several determinants of exchange rate including;inflation, interest rates, income levels, Balance of Payments, Productivity,speculation, increase in competitiveness and relative strength of other currencies.
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