Factors deciding Exchange rates:-

G lobal market for foreign exchange currencies is massive! - Hundreds of billions of £s

and $s are traded in the dealing rooms each day. The market is open 24 hours a day for
people, companies and governments needing foreign exchange to finance their
transactions. Money now moves round the international financial system at tremendous
speed (aided by the spread of computer technology and the gradual abolition of exchange
controls between countries). Speculative activity in the market is a major determinant of a
currency's value.

Short and long-term movements in the exchange rate, like any price, are caused by
changes in market demand and supply conditions

Demand for Sterling

The demand for sterling (pounds) in the FOREX markets comes from four main sources:

• An export increases the demand for the currency increases (as the value of the
goods exported u has to pay in that currency).
• foreign investment flows into the UK economy
• market speculators decide they want to purchase pounds in the expectation of
making a profit
• official buying of the currency by the central bank

An outward shift in the demand for sterling will cause an appreciation in the currency
Supply of Sterling

Sterling is sold on foreign exchange markets when

• Goods and services are imported (domestic consumers and firms sell currency to
buy the imports hence the supply of currency in the forex markets increases)
therefore the currency depreciates.
• speculators sell pounds for another currency
• investment capital flows out of the UK seeking a better rate of return
• central banks go into the market and sell pounds to buy other foreign currencies

As figured from the figure as the supply curve shifts the currency depreciates.
Fundamental factors that drive an exchange rate

INTEREST RATES

Interest rates have a large effect in a world where financial capital can move freely
between countries.

When a country's interest rates are high relative to elsewhere this attracts inflows of
money into a country seeking to take advantage of the high interest rates. This "interest
differential" boosts the demand for the currency and can cause its value to rise.

ECONOMIC GROWTH

Countries experiencing a deep recession often find that their exchange rate is weakening.
Traders in the currency markets may take the slow growth to be a sign of general
economic weakness and "mark down" the value of the currency as a result.

On the other hand, economies with strong "export-led" growth may see their currency's
rise in value. Japan is a good example of this in recent years. The Euro was weak during
the first six months of its existence in part because the financial markets were worried
about the slow growth of the European economy and the persistently high level of
unemployment.

INFLATION

In the long run, those countries with higher than average inflation see their exchange rate
fall. When inflation is high, a country becomes less competitive in international markets
causing a fall in exports (a demand for a currency) and a rise in imports (a supply of
currency overseas). A fall in the exchange rate may be needed to restore a country's
competitiveness in overseas

MARKET SPECULATORS

Special factors (such as political events, changing commodity prices etc.) can have an
effect on a currency. In addition the power of market speculators has grown. When
speculators decide that a currency is going to fall in value, they sell that currency and buy
ones they anticipate will rise in value.
It is difficult for government's to offset the power of speculators because their reserves of
foreign currencies are very small compared to daily turnover in the market. We saw in
1997 and 1998 speculative attacks on currencies in Asia and seven years ago, the pound
was forced out of the European exchange rate mechanism because of speculative selling
of the pound.

Macro-economic effects of currency movements

Inflation

Suppose for easy consider Indian currency depreciates (i.e. It’s value in terms of dollar
decreases):-

• it will make imports (now for the same good more rupees has to be paid) expensive.

• Producers may pass on higher costs of imported components and raw materials onto
consumers. This depends on the price elasticity of demand for the product

• Wages may rise in response to this triggering off the possibility of a wage-price spiral

Exports

• Exporters should benefit from a lower rupee. It makes Indian goods cheaper when
priced in a foreign currency - demand for Indian exports should rise

• The foreign elasticity of demand for Indian goods and the level of income overseas
determine the effect on the demand for exports. Hopefully the demand for Indian goods
will be relatively elastic

• Exporting firms may decide to hold export prices constant and take higher profits

Imports

• Demand for imports should fall as imports become more expensive

• Some imports are essential for production or cannot be made in the Indian and have an
inelastic demand - we will end up spending more on these Balance of Payments (Export –
Imports).

• Normally, depreciation improves the balance of payments by reducing demand for

imports and increasing demand for exports.

• However in the short term there may be a J curve effect, which causes the balance of
trade in goods and services to deteriorate Economic Growth

• Higher exports and falling imports lead to rising GDP levels

• A lower exchange rate might be accompanied by lower interest rates which will
stimulate consumer spending

the j curve effect

In the short term a devaluation or depreciation of the exchange rate may not improve
the current account deficit of the balance of payments. This is due to the low price
elasticity of demand for imports and exports in the immediate aftermath of an exchange
rate change. The diagram below shows this possibility.
Assuming that the economy begins at position A with a substantial current account deficit
there is then a fall in the value of the exchange rate. Initially the volume of imports will
remain steady partly because contracts for imported goods will have been signed.

However, the depreciation raises the sterling price of imports causing total spending on
imports to rise. Export demand will also be inelastic in response to the exchange rate
change in the short term, therefore the earnings from exports may be insufficient to
compensate for higher spending on imports. The current account deficit may worsen for
some months. This is shown by the movement from A to B on the diagram.