6 Factors That Influence

Exchange Rates
Aside from factors such as interest rates and inflation, 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. But exchange rates matter on a smaller scale
as well: they impact the real return of an investor's portfolio. Here we look at some of the major
forces behind exchange rate movements.

Overview
Before we look at these forces, we should sketch out how exchange rate movements
affect a nation's trading relationships with other nations. A higher currency makes a
country's exports more expensive and imports cheaper in foreign markets. A lower
currency makes a country's exports cheaper and its imports more expensive in foreign
markets. A higher exchange rate can be expected to lower the country's balance of
trade, while a lower exchange rate would increase it.

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. Note that
these factors are in no particular order; like many aspects of economics, the relative
importance of these factors is subject to much debate.

[ There are many fundamental factors such as those discussed below that
determine exchange rates. Successful traders often look to combine the
fundamentals with technical factors such as chart patterns, indicators and
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1. Differentials in Inflation

As a general rule, a country with a consistently lower inflation rate exhibits a rising
currency value, as its purchasing power increases relative to other currencies. During
the last half of the 20th century, the countries with low inflation included Japan,
Germany and Switzerland, while the U.S. and Canada achieved low inflation only later.
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 for goods, services, interest and dividends. 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 until domestic goods and services are cheap enough
for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

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. 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.

In the worst case scenario, a government may print money to pay part of a large debt, but
increasing the money supply inevitably causes 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 & Poor's, for example) is a crucial determinant of its
exchange rate.
 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.

The Bottom Line

The exchange rate of the currency in which a portfolio holds the bulk of its investments
determines that portfolio's real return. A declining exchange rate obviously decreases the
purchasing power of income and capital gains derived from any returns. Moreover, the exchange
rate influences other income factors such as interest rates, inflation and even capital gains from
domestic securities. While exchange rates are determined by numerous complex factors that
often leave even the most experienced economists flummoxed, investors should still have some
understanding of how currency values and exchange rates play an important role in the rate of
return on their investments.

Government Intervention in the

Foreign Exchange market
Under certain circumstances, the government might want to intervene in the foreign
exchange markets to influence the level of the exchange rate.

Methods to Influence the Exchange Rate

1. Reserves and Borrowing. If the value of an exchange rate is falling and the government wants
to maintain its original value it can use its foreign exchange reserves e.g. selling its dollars
reserves and purchase pounds. This purchase of Pound sterling should increase its value.

2. Borrow The government can also borrow foreign currency from abroad to be able to buy
sterling.
3. Changing interest rates (In UK this is now done by the MPC) higher interest rates will cause
hot money flows and increase demand for sterling. Higher interest rates make it relatively more
attractive to save in the UK.

4. Reduce Inflation

Through either tight fiscal or Monetary policy Aggregate Demand and hence inflation can be
reduced.
By decreasing AD consumers will spend less and purchase less imports and so will supply less
pounds. This will increase the value of the ER
Lower inflation rate will also help because British goods will become more competitive. Thus the
demand for Sterling will rise.

However this policy has an obvious side effect because lower AD will cause lower
growth and higher unemployment

5. Supply side measure to increase the competitiveness of the economy. This will take along time
to have an effect.

UK forced out of Exchange Rate Mechanism

Note: Governments often fail in their attempt to influence the exchange rate. In 1992 the
was in the ERM but struggled to keep its value against the DM. The Pound Sterling
kept falling to its lower limit in the exchange rate mechanism.

In response the government raised interest rates to 15% and bought Pound Sterling on
the foreign currency reserves. However this was insufficient to stop the falling.
Eventually the govt had to give into market pressures and exit the ERM.

The govt intervention failed because the market felt the governments intervention was
not sustainable. Interest rates of 15% were disastrous for an economy already in
recession.

This shows the limit of governmnets intervention.

Factors which influence the exchange

rate
Exchange rates are determined by factors, such as interest rates, confidence, the
current account on balance of payments, economic growth and relative inflation rates.
For example:
 If US business became relatively more competitive, there would be greater demand for
American goods; this increase in demand for US goods would cause an appreciation (increase
in value) of the dollar.
However, if markets were worried about the future of the US economy, they would tend to sell
dollars, leading to a fall in the value of the dollar.

Determination of exchange rates using supply and demand diagram

In this example, a rise in demand for Pound Sterling has led to an increase in the value
of the to $ from 1 = $1.50 to 1 = $1.70

Note:

Appreciation = increase in value of exchange rate

Depreciation / devaluation = decrease in value of exchange rate.

Factors that influence exchange rates

1. Inflation
 If inflation in the UK is relatively lower than elsewhere, then UK exports will become
more competitive, and there will be an increase in demand for Pound Sterling to buy UK
goods. Also, foreign goods will be less competitive and so UK citizens will buy fewer
imports.

Therefore countries with lower inflation rates tend to see an appreciationin the value of their
currency. For example, the long-term appreciation in the German D-Mark in the post-war period
was related to the relatively lower inflation rate.

2. Interest rates

If UK interest rates rise relative to elsewhere, it will become more attractive to deposit
money in the UK. You will get a better rate of return from saving in UK banks. Therefore
demand for Sterling will rise. This is known as hot money flows and is an important
short-run factor in determining the value of a currency.

Higher interest rates cause an appreciation.

Cutting interest rates tends to cause a depreciation

3. Speculation

If speculators believe the sterling will rise in the future, they will demand more now to be
able to make a profit. This increase in demand will cause the value to rise. Therefore
movements in the exchange rate do not always reflect economic fundamentals but are
often driven by the sentiments of the financial markets. For example, if markets see
news which makes an interest rate increase more likely, the value of the pound will
probably rise in anticipation.
The fall in the value of the Pound post-Brexit was partly related to the concerns that the
UK would no longer attract as many capital flows outside the Single Currency.

4. Change in competitiveness

If British goods become more attractive and competitive this will also cause the value of
the exchange rate to rise. For example, if the UK has long-term improvements in labour
market relations and higher productivity, good will become more internationally
competitive and in long-run cause an appreciation in the Pound. This is a similar factor
to low inflation.

5. Relative strength of other currencies

In 2010 and 2011, the value of the Japanese Yen and Swiss Franc rose because
markets were worried about all the other major economies US and EU. Therefore,
despite low-interest rates and low growth in Japan, the Yen kept appreciating. In the
mid-1980s, the Pound fell to a low against the Dollar this was mostly due to the
strength of Dollar, caused by rising interest rates in the US.

6. Balance of payments
A deficit on the current account means that the value of imports (of goods and services)
is greater than the value of exports. If this is financed by a surplus on the
financial/capital account, then this is OK. But a country which struggles to attract
enough capital inflows to finance a current account deficit will see a depreciation in the
currency. (For example, current account deficit in US of 7% of GDP was one reason for
depreciation of dollar in 2006-07). In the above diagram, the UK current account deficit
reached 7% of GDP at the end of 2015, contributing to the decline in the value of the
Pound.

7. Government debt

Under some circumstances, the value of government debt can influence the exchange
rate. If markets fear a government may default on its debt, then investors will sell their
bonds causing a fall in the value of the exchange rate. For example, Iceland debt
problems in 2008, caused a rapid fall in the value of the Icelandic currency.

For example, if markets feared the US would default on its debt, foreign investors would
sell their holdings of US bonds. This would cause a fall in the value of the dollar.
See: US dollar and debt

8. Government intervention
 Some governments attempt to influence the value of their currency. For example, China
has sought to keep its currency undervalued to make Chinese exports more
competitive. They can do this by buying US dollar assets which increases the value of
the US dollar to Chinese Yuan.

see also: Chinese Currency | Swiss Franc pegged against Euro

9. Economic growth/recession

A recession may cause a depreciation in the exchange rate because during a recession
interest rates usually fall. However, there is no hard and fast rule. It depends on several
factors. See: Impact of recession on currency.

Example fall in value of Sterling 2007 Jan 2009

Sterling exchange rate index, which shows the value of Sterling against a basket of currencies.

During this period 2007-09, the value of Sterling fell over 20%. This was due to:

Restoring UKs lost competitiveness. The UK had large current account deficit in 2007
Bank of England cut interest rates to 0.5% in 2008.
The recession hit UK economy hard. Markets expected interest rates in the UK to stay low for a
considerable time.
Bank of England pursued quantitative easing (increasing the money supply). This raised the
prospect of future inflation, making UK bonds less attractive.