Question

Some currencies depreciate and others appreciate. Explain the factors that determine the fluctuation of exchanges rates.

Answer 1

Exchange rates fluctuate as a result of many factors which may affect the exchange rate individually or in combination. These factors and effects may be internal or international. These factors are:

1. Inflation rate:If the inflation rate in a country is lower than the other country, then there will be an appreciation in the value of its currency. Hence exchange rate rises.

2. Interest rate: If a country has a higher interest rate, then it will attract more investors (because of higher returns). The currency appreciates and demand for its currency will be higher and hence higher exchange rate.

3. Balance of Payment: A deficit BoP (excess imports over exports) leads to depreciation of its curency and leads to fluctuation in exchange rates internally.

4. Terms of trade: If the country's ToT has export prices lower than import prices, then the country has lower revenue which reduces the demand for its currency and decreases its value. Thus exchagne rate will be depreciated.

5. Recession: During recession, interest rate is likely to fall. Buying foreign capital becomes more expensive. It mens that the country's currency is weaker; exchange rate falls.

6. Future value: If a country's currency is expected to rise in the near future, there will be more demand for it in the present in the desire of making a profit when the value rises. Hene the currency appreciates, increasing the exchange rate.