Question

What factors Influence the differences in currency exchange rates?

Answer 1

Factors that influence the differences in currency exchange rates

A country's exchange rate is one of the most important determinant of its economic well being.It plays an important role in the level of trade of the country in the global market and so it is analyzed and manipulated by the government.When a country has a higher valued currency its imports are less expensive whereas the exports become more expensive,this improves the balance of trade,on the other hand when a country has a lower valued currency,imports become more expensive and exports are less expensive,this worsens the balance of trade.

DETERMINANTS OF DIFFERENCES IN CURRENCY EXCHANGE RATES

The currency exchange rate is the rate at which one country's currency is converted into another country's currency.Its not constant and keeps on fluctuating.The following factors influence the fluctuations in the currency rates.

INFLATION

A relatively low inflation rate of a country increases the value of currency and further increases its purchasing power in comparison to other countries.Similarly a high rate of inflation depreciates the value of the country's currency.

RATE OF INTEREST

There is a strong correlation between the rate of interest and the inflation rate of a country. A high rate of interest gives better return to investors and so it increases the value of the country's currency.Similarly a low rate of interest does not attract the investors and so it depreciates the value of the country's currency.

GOVERNMENT DEBT

A country which has a large government debt,is less attractive to foreign investors,as they fear this debt may lead to high inflation in the country and thus depreciate the value of currency.As a result the country looses to new investors also the existing investors withdraw their investments fearing default in payment which further brings down the value of the country.

SPECULATION

Speculation plays an important part in the value of currency in the international market as a majority of transactions in global trade are based on speculations.If investors feel that value of the currency of a currency may rise in the future,they will demand more of it in order to make profit in the future.This increase in the demand for a currency appreciates its value and thus increases its exchange value.

POLITICAL STABILITY

Political stability affects the economic performance of any country and also the value of currency.A country which has a stable political system is attractive to the investors as they are positive about the returns on their investment leaving no room for uncertainty,thus appreciating the value of the currency.On the other hand a country having a political turmoil does not attract investors thus there is no demand for its currency and so its value is depreciated.

BALANCE OF PAYMENTS

The current account shows the balance of trade between the transactions of the country with other countries.It reflects all the payments made as well as received for trade of various goods and services as well as interests and dividends.A deficit in the current account of a country depicts that its imports exceed its exports.Thus the country is spending more of its currency in the global market and not earning enough foreign currency as the it imports more goods.The value of the currency with a deficit is thus depreciated.Balance of payments thus fluctuates the value of currency.

TERMS OF TRADE

It is the ratio which compares the export prices to the import prices,thus it is related to the current account and balance of payments.A country's terms of trade improve when the price of its exports rise at a greater rate than its imports,which shows that there is a greater demand for the country's exports.As a result the revenues from exports increase,thus the demand for the country's currency increases and its leads to an increase in the value of its currency.

The exchange rate of the currency plays an important part in the returns which the investors receive for their investments,which in turn affects the demand for the currency.