Question

What are the factors that influence exchange rate .Write a brief note on it

* Inflation .

* interest Rates .

* Income .

* Government Controls

* Expectations .

Answer 1

* Inflation .

Typically, 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.

* 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.

* Government Controls

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.

* Income .

Another factor affecting exchange rate is the relative income level. Income level of the country determines the imports demanded which affects the exchange rate.

If the US income level rises while the British level of income remains the same. The scenario will represents three situations: a) the demand schedule for pounds will shift outward reflecting the increase in US income and therefore increased demand for British goods, b) the supply schedule of pounds for sale is not expected to change, c) exchange rate of pounds will rise.

* Expectations

Speculators make profit through the margin they seek in buying and selling of currencies. If speculators believe that pound will rise in near future, they will demand more now to be able to make more profit. This increase in demand will cause the value to rise. Movement in the exchange rate is not always directed by the economic fundamentals, but driven by sentiments of financial markets.