In: Accounting
1-Determination of exchange rates depends on factors causing fluctuations.
a-Explain why and its effect on US dollar
b-Distinguish between DER & IER.
1.
a.
Foreign Exchange rate (ForEx rate) is one of the most important means through which a country’s relative level of economic health is determined. A country's foreign exchange rate provides a window to its economic stability, which is why it is constantly watched and analyzed. If you are thinking of sending or receiving money from overseas, you need to keep a keen eye on the currency exchange rates.
The exchange rate is defined as "the rate at which one country's currency may be converted into another." It may fluctuate daily with the changing market forces of supply and demand of currencies from one country to another. For these reasons; when sending or receiving money internationally, it is important to understand what determines exchange rates.
Factors effecting -
1. Inflation Rates
Changes in market inflation cause
changes in currency exchange rates. A country with a lower
inflation rate than another's will see an appreciation in the value
of its currency. The prices of goods and services increase at a
slower rate where the inflation is low. A country with a
consistently lower inflation rate exhibits a rising currency value
while a country with higher inflation typically sees depreciation
in its currency and is usually accompanied by higher interest
rates
2. Interest Rates
Changes in interest rate affect
currency value and dollar exchange rate. Forex rates, interest
rates, and inflation are all correlated. Increases in interest
rates cause a country's currency to appreciate because higher
interest rates provide higher rates to lenders, thereby attracting
more foreign capital, which causes a rise in exchange
rates
3. Country’s Current Account / Balance of Payments
A country’s current account reflects
balance of trade and earnings on foreign investment. It consists of
total number of transactions including its exports, imports, debt,
etc. A deficit in current account due to spending more of its
currency on importing products than it is earning through sale of
exports causes depreciation. Balance of payments fluctuates
exchange rate of its domestic currency.
4. Government Debt
Government debt is public debt or
national debt owned by the central government. A country with
government debt is less likely to acquire foreign capital, leading
to inflation. Foreign investors will sell their bonds in the open
market if the market predicts government debt within a certain
country. As a result, a decrease in the value of its exchange rate
will follow.
5. Terms of Trade
Related to current accounts and
balance of payments, the terms of trade is the ratio of export
prices to import prices. A country's terms of trade improves if its
exports prices rise at a greater rate than its imports prices. This
results in higher revenue, which causes a higher demand for the
country's currency and an increase in its currency's value. This
results in an appreciation of exchange rate.
6. Political Stability & Performance
A country's political state and
economic performance can affect its currency strength. A country
with less risk for political turmoil is more attractive to foreign
investors, as a result, drawing investment away from other
countries with more political and economic stability. Increase in
foreign capital, in turn, leads to an appreciation in the value of
its domestic currency. A country with sound financial and trade
policy does not give any room for uncertainty in value of its
currency. But, a country prone to political confusions may see a
depreciation in exchange rates.
7. Recession
When a country experiences a
recession, its interest rates are likely to fall, decreasing its
chances to acquire foreign capital. As a result, its currency
weakens in comparison to that of other countries, therefore
lowering the exchange rate.
8. Speculation
If a country's currency value is
expected to rise, investors will demand more of that currency in
order to make a profit in the near future. As a result, the value
of the currency will rise due to the increase in demand. With this
increase in currency value comes a rise in the exchange rate as
well.
Conclusion:
All of these factors determine the foreign exchange rate
fluctuations. If you send or receive money frequently, being
up-to-date on these factors will help you better evaluate the
optimal time for international money transfer. To avoid any
potential falls in currency exchange rates, opt for a locked-in
exchange rate service, which will guarantee that your currency is
exchanged at the same rate despite any factors that influence an
unfavorable fluctuation.