Factors That Determine the Currency Exchange Rates

Topics: Foreign exchange market, Bretton Woods system, Inflation Pages: 17 (4524 words) Published: April 3, 2008
Factors that Determine the Currency Exchange Rates

Exchange rate is often referred to as the nominal exchange rate. It is defined as the rate at which one currency can be converted, or 'exchanged', into another currency. For example, the pound is currently worth about 1.824 US dollars. One pound can be converted into 1.824 dollars. This is the exchange rate between the pound and the dollar. There are four types of currencies can be operated, which are a floating, managed and fixed exchange rate.

Lots of developed industrial nations like US ($), UK (???) and Japan (??¥) operate floating exchange rates. A floating exchange rate is known as freely floating and should be self-regulating. It is often determined by the market demand and supply without any other government or official interference. As the exchange rate between pound and dollar for example, the price of pound in terms of dollar would decided by the demand for pounds from whom hold dollars and the supply of pounds from sterling holder who want to buy dollars. When people in the UK try to buy US goods and services they will supply pounds to US, however, when people from US try to by UK goods and services they will demand UK pounds. At this time, the price which keeps the demand and supply force in balance is the exchange rate between pound and dollar. As it shows in

[IMAGE]Price of ???s in $s S D


(FIGURE 1.1)


0 Q Quantity of???s

figure1.1, when one pound equals one and a half dollars, the price is in equilibrium.

Although floating exchange rate is mainly affect by market forces, actually sometimes a nation's central bank try to influence the exchange rate. They can use the way of adjusting the interest rate to influence the capital flow into or out of the country or directly buying or selling the currency. The reason central bank try to manage the exchange rate is to reduce the fluctuations around the equilibrium exchange rate they believed. The ERM which stands for the exchange rate mechanism is an example of a managed exchange rate. It is fundamentally for preventing large fluctuations relative to European Union's (EU) countries' currencies. the member countries of EU have to keep their currencies value within a permitted band. Country has to take actions to bring its exchange rate value within the set band when its currency moves out of it. As it shows in figure1.3 that there is an increase in demand for imports, then lead the supply curve to shift right from S to S'. In order to lower the price of the currency, the country may take actions such as raising its domestic interest rates or buy its own currency. This results demand curve shifts right from D to D' and keep the value of the exchange rate within the band.

Price of currency in Euros



D S'

Upper margin

Lower margin




Figure 1.2

A fixed exchange rate is a kind of currency whose value has fixed against another or other currencies. And the currency is not allowed to appreciate or depreciate against each other. It is guaranteed and totally controlled by the government. In order to keep a currency at a fixed value, the central bank must prepare to buy and sell the currency at the fixed price. In that case, central bank has to find the foreign currency supply. China is an example for operating a fixed exchange rate system and the exchange rate is fixed to US dollar at 1 US dollar = 8.73 RMB. Assume that, RMB has a fixed value to dollar that 1US dollar= 8 RMB, but now the imports in China increase, as it shows in figure 1.3, the supply curve moves from S to S', at the same time RMB in terms of dollar just 1US dollar=5 RMB. The central bank which is The Bank of China enters the market and buys its own currency raising demand from D to D' and keep the price at the level of 1 US dollar=8 RMB.


Figure 1.3

Generally, governments often use government policy to influence the value of their currency If the country is...
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