Determination Of Exchange Rates

Exchange rates represent the value of one currency compared to another. They fluctuate due to supply and demand, inflation, interest rates, trade balance, and investor confidence. Governments and central banks also influence rates through policy. These rates often affect imports, exports, travel, and investments, making them vital indicators of global economic health.

Key Highlights

• Factors like inflation, speculation, interest rates, competitiveness, and government debt affect exchange rates.

• There are different levels of government intervention in fixed, pegged floating, and floating exchange rate systems.

• Lower inflation rates can boost the demand for a nation's currency and increase the competitiveness of its exports.

• As investors look for higher returns, disparities in interest rates among nations have an impact on currency rates.

Exchange Rate Determination

The exchange rate of currencies may be determined using a variety of techniques. Popular techniques include:

Floating Exchange Rate

A floating exchange rate is a currency system where the value of a country’s currency is determined by market forces of supply and demand relative to other currencies. Unlike fixed exchange rates, it is not pegged to another currency or a commodity like gold. Instead, the rate fluctuates freely, adjusting to economic conditions such as inflation, trade flows, interest rates, and investor sentiment. Central banks may intervene occasionally to stabilise extreme volatility, but the system largely runs on market dynamics.

For example, the Indian Rupee (INR) against the US Dollar (USD) operates under a managed floating system. If demand for Indian exports rises, the INR strengthens. Conversely, heavy imports or capital outflows weaken the rupee against the dollar.

Hybrid Systems

Hybrid Exchange Rate Systems combine features of fixed and floating regimes, giving countries flexibility while maintaining some control over their currency. They aim to balance stability with the ability to respond to market pressures. Instead of committing fully to a fixed peg or a free float, governments adopt mechanisms that adjust gradually or within set limits.

Crawling Peg: In this system, the currency is pegged to another but adjusted periodically in small increments, either up or down. Adjustments reflect inflation differentials or trade imbalances. For instance, a country may let its currency depreciate by 1% monthly to maintain competitiveness.

Crawling Band: Here, the currency fluctuates within a band around a central rate, and the band itself shifts gradually over time. This allows more flexibility than a simple crawling peg while still providing predictability.

Horizontally Pegged: The exchange rate is kept fixed within a narrow, unchanging band. The central bank intervenes whenever the currency threatens to move outside this band. This offers stability, but it requires strong reserves to defend the peg against market pressures.

These hybrid systems are often used by emerging economies seeking controlled flexibility.

Fixed Exchange Rate

A fixed exchange rate is a currency system where a country’s central bank or government pegs its currency to another currency (commonly the US dollar) or a basket of currencies. Unlike a flexible exchange rate, which is determined mainly by market forces of demand and supply, a fixed regime requires constant intervention. The central bank maintains the chosen rate by actively buying or selling foreign currency reserves to prevent large deviations. This provides stability in international trade and investment, but also limits monetary policy flexibility.

Suppose the government fixes the exchange rate at ₹75 per US dollar, while actual market conditions value it closer to ₹70. In this case, dollars appear overvalued because exchanging at ₹75 yields more rupees than the real market rate of ₹70. As a result, more people convert dollars into rupees, creating excess supply of dollars relative to demand. The central bank would then need to step in and absorb the extra supply to maintain the fixed rate.

Factors Affecting Exchange Rates

The following are the key factors that affect the exchange rate of currencies.

1. Inflation

Inflation plays a major role in determining exchange rates. When a country maintains a lower inflation rate compared to others, its goods and services become more competitive internationally. This increases demand for its currency, as foreign buyers need it to purchase those goods. At the same time, domestic consumers are less likely to import expensive foreign products, supporting the local currency further. As a result, countries with consistently low inflation often experience an appreciation in their currency over the long term.

For example, Japan’s relatively low inflation in the late 20th century supported the yen’s strength, while high inflation in nations like Argentina or Turkey has historically contributed to sharp currency depreciations.

2. Speculation

Speculation influences exchange rates when investors and traders anticipate future currency movements. If market participants expect a currency to strengthen, they tend to buy and hold it, increasing demand and pushing its value higher. Conversely, if they anticipate a decline, they may sell or shift into more stable currencies, causing depreciation. This behaviour often amplifies short-term fluctuations, even when underlying economic fundamentals remain unchanged.

For instance, expectations around U.S. Federal Reserve interest rate decisions frequently drive speculative movements in the U.S. dollar.

3. Interest Rates

The value of exchange rates is significantly influenced by the variance in interest rates between nations. Banks, multinational corporations, and wealthy investors spend money all across the world to increase profits. This has a significant impact on a country's exchange rates as well.

4. Change in Competitiveness

A country’s exchange rate is influenced by its overall competitiveness in global markets. When a nation’s goods and services become more attractive due to factors such as higher productivity, technological advancements, or efficient labour markets, demand for its exports rises. This increased demand boosts the need for its currency, leading to appreciation. Over time, structural improvements in competitiveness can strengthen a currency much like sustained low inflation does.

For example, Germany’s strong manufacturing base and productivity gains have historically supported the euro, while South Korea’s rise in global electronics and automobile competitiveness has contributed to the long-term strength of the won.

5. Balance of Payments

When the value of imports (of goods and services) exceeds the value of exports, there is a current account deficit. This is acceptable if it is financed by a financial/capital account surplus. However, currency depreciation will occur in a nation that finds it difficult to draw sufficient capital inflows to sustain a current account deficit.

6. Government Debt

The value of government debt may occasionally have an impact on the exchange rate. Investors will sell their bonds if markets believe a government will be unable to pay its debt, which would lower the value of the exchange rate. For instance, Iceland's 2008 debt issues led to a sharp decline in the value of the Icelandic currency.

7. Political and Economic Stability

Political and economic stability strongly influence exchange rates by shaping investor confidence. Countries with stable governments, transparent policies, and consistent economic growth attract more foreign investment, increasing demand for their currency and supporting appreciation. On the other hand, political uncertainty, frequent policy changes, corruption, or conflict can drive investors away, leading to capital flight and currency depreciation.

For example, Switzerland’s long-standing political stability and sound economic management have made the Swiss franc a safe-haven currency. In contrast, episodes of political and economic turmoil in countries like Venezuela or Zimbabwe have triggered severe currency devaluations due to collapsing investor trust.

Exchange Rates in the Long Run

In a flexible exchange rate framework, long-term predictions about the exchange rates are made using the notion of PPP or purchasing power parity. According to the theory, exchange rates must gradually adjust so that the same products cost the same prices regardless of whether they are quantified in rupees in India, yen in Japan, or dollars in the US, with the exception of the differences in transportation. This is because there are no business frontiers like taxes (tariffs on business) and quotas (quantitative constraints on imports).

Conclusion

Determination of the exchange rate is crucial. Everyone is impacted by changes in currency rates since it is the engine that drives an economy. Governments, therefore, work to raise the value of their national currencies to manage the balance of payments in a satisfactory manner. The net difference between a country's total imports and exports is known as its balance of payments. Therefore, when exchange rates are high, a smaller amount of cash may bring you more goods on global marketplaces. This enhances the value that nations provide to their residents by assisting them in managing a healthy rate of economic growth.

Also Read

https://www.kotaksecurities.com/stockshaala/introduction-to-fundamental-analysis/impact-of-exchange-rates-and-foreign-trade-stock-market/