Factors affecting Exchange Rate

Monitory Policy

If the Central Banks thinks that any sort of intervention in the foreign exchange market would remain consistent with the monitory policy of the government, it will take part in the trading of foreign exchange and in the influencing of the exchange rates. Generally, a central bank does this by the buying and selling of the home currency in order to stabilize it to a required level.

For example, when 1987 was at an end, the US Dollar was under the effect of major continuous depreciation and in order to stabilize the value of US Dollar, the finance ministers of the country released a joint statement  that they would be intervening in the forex market.

Political Situation

Political situation of a country is very effective in influencing that country’s exchange rates. Any political tension will result in instability of the exchange rates. If there is political instability in a country, then there will be irregular inflow or outflow of that country’s currency. Such irregular behavior in a country’s currency purchases causes fluctuations in its exchange rates. And if the political situation of any country is stable then it will experience stable exchange rates.

For example, during the Kosovo war for three consecutive months the Euro fell by 10 perecnt against the US Dollar because of downward pressure of the war.

Balance of Payments

Balance of payments of a country reflects all its economic dealings of that country with the rest of the world. Balance of payments of a country also causes fluctuations in the exchange rates. It also affects the demand and supply of that country’s currency. Any sort of economic activity that results in an inflow of foreign investment will result in foreign revenue. Only the home currency of a country is allowed to be circulated in it so the foreign currency will have to be converted to domestic currency first which creates a supply of those foreign currencies in the foreign exchange market. Whereas, all those economic activities that result in an outflow of capital would result in domestic currency being converted to foreign currency and create a supply of domestic currency in the forex market. Both of these and other imbalances in the balance of payments cause fluctuations in the foreign exchange markets.

For example, one of the reasons of dollar depreciation in the United States in 2006-2007 was a current account deficit in the country of 7 percent.

Interest Rates

If one country’s interest rates go higher or lower in comparison to another country’s currency, then the country with the higher interest rates will be bought in order to gain high returns. Since this will create a demand for that currency, then its value will increase as compared to other currencies.

For example, one of the reasons for the fall in the value of UK Pound Sterling in 2007 to 2009 was a 0.5 percent drop in the interest rates.

Market Judgment

There is no logical or set pattern on which the foreign exchange market works. There are certain irrational and intangible factors at work as well such as emotions, rash behavior of the people, analysis, judgments, comprehensions etc. It is the job of market operators to interpret the data and make judgments as to how the market will behave based on those interpretations and these will also be reflected on the prices. If the actual market actions deviate from the judgments and reports, then there are seen fluctuations in the exchange market.

For example, the market judged ahead of time the drop in the value of Canadian dollar during the time period of 1997 to 1999.

Speculation

Speculation of the market rates is also another factor that affects the exchange rates. Mostly, the transactions are speculative trading while in reality the percentage of those transactions that are linked to international trades is lower. Speculation sometimes forces a certain action like it may result in a frenzy buying of one currency which will end up fulfilling the prediction. On the other hand, if a market speculates a certain drop in the value of some currency, then it might also result in people selling the currency and end up force proving the speculation. 

For example, from 1960s to 1970s, there were many scandals in the US including the Vietnam War and Watergate scandal. The Speculators predicted a drop in the value of US dollar and it did drop as well.

Inflation

Countries that have low inflation rates get their currency values appreciated. If inflation is low in one country, then it means that the prices of the goods of that country will be lower as compared to the same kind of goods of other countries. This kind of competition will result in people willing to purchase that currency in order to purchase goods from there and this will create a demand for that currency in the forex markets.

For example, in 2008 there was extremely high inflation in Zimbabwe due to which one US Dollar became equal to 600,000,000,000,000,000 Zimabwean Dollars.

Change in competitiveness

If the goods of one country start competing with other international goods of the same kind, then it will also create a demand for that currency in the forex market as people will have to purchase that currency in order to purchase those goods and its exchange rates will rise.

For example, when Japanese Yen increased in value then its people could afford more of the international goods. 

Relative strength of other currencies

If the strength of some major currency is in doubt, then people will start purchasing other currencies that they deem safer and this will create a demand for it in the forex market, pushing its exchange rates higher.

For example, after 2007 when Benzair Bhutto was assassinated in Pakistan, people were in doubt of the strength of the currency and started selling it which resulted in a decline in its value in the forex market.

Government Debt

The value of a debt that a government is under also influences the exchange rates of that currency. For example, if there is a fear of the government defaulting on its debt then investors will start selling that currency which will cause its exchange rates to fall.

For example, Iceland had major debt problems in 2008 due to which the currency of the country saw a very rapid fall in its value.

Government Intervention

Governments sometime intervene in the foreign exchange markets to keep the values of their currencies at a set level. If they want their currencies to be appreciated then they will purchase their own currencies at the exchange market, thus keeping the currency value high.

For example, to make their products remain competitive in the international market, the Chinese government intervened to have Chinese Yuan devalued in comparison of US Dollar.

Economic growth / recession

In case of recession in the economy, the interest rates of a country fall which is why its currency gets depreciated. On the other hand, when there is growth in the economy, the interest rates go up, causing an appreciation in the value of that currency.

For example, when there was severe recession in the UK, the UK Pound Ssterling fell nearly 20 percent in its value in the international market.

Trade Balance

The trade balance or balance of trade of a country is the value that we get after subtracting its total imports from its total exports. The country has favorable balance of trade if the resultant is positive and unfavorable if it is negative. It impacts the supply and demand of the currency of the country. In case of favorable balance of trade, demand for its currency increases, whereas, it falls down in the other case

Public Debt

Governments usually engage in the activity of deficit financing at a large scale in order to make payments for capital or public projects. Even though such activities are good for the domestic economy, yet such large public debts and public deficits give a poor impression to foreign investors. Increase in money supply and large debts also result in an inflationary situation in the economy due to which currency value gets lowered.