Factors That Determine a Currency's Value

Topics: Inflation, Exchange rate, Bretton Woods system Pages: 13 (3840 words) Published: February 10, 2013
FIN341- Multinational Financial Management

“What determines a currency’s value?”

Number of words: 3.239

Table of Content

Table of FiguresII
List of AbbreviationsIII
1Introduction- 1 -
2Factors that determine a currency’s value- 1 -
2.1Inflation- 1 -
2.2Interests rates- 3 -
2.3Trade and Investment- 4 -
2.4Economy- 6 -
2.4.1Economic indicators- 6 -
2.4.1Economy and Economic Theory- 7 -
2.4.2Industry- 7 -
2.5Government policy- 8 -
2.6Other factors influencing a currency’s value- 9 -
3Conclusion- 11 -
Reference List- 12 -

Table of Figures

Figure 1: US Trade Deficit (%GDP)5

List of Abbreviations

CPI Consumer Price Index
GDPGross Domestic Product
IFE International Fisher Effect
PPPPurchasing Power Parity

Increasing exchange rate fluctuations, such as those that have occurred in the US dollar, have recently revived the discussion about the causes of such movements and the criteria for calculating the long-term over- or undervaluation of a currency. Currency can be defined as any form of money that is in public circulation. Currency includes both coins and soft money paper money. Typically currencies are used as a medium of exchange for goods and services. The exchange rate indicates the price of a currency and plays therefore an important role.[1] Also when investing or purchasing in a foreign currency, it is important to understand the factors that determine a currency’s value. Investors are often exposed to different currencies, companies have overseas earnings, and many funds invest abroad. Exchange rate movements will therefore impact the returns of a business.[2] In the following this paper examines several factors that influence a currency’s value.

Factors that determine a currency’s value

1 Inflation

The first aspect that influences a currency’s value is the inflation. Inflation can be defined as the overall general upward price movement of goods and services in an economy.[3] Inflation is being measured by the inflation rate. The inflation rate is determined by the percentage rate of change in price level over time and can be defined as follows:

Inflation rate = [P(t)-P(t-1)] / P(t-1)*100%

A larger amount of currency in circulation can lower the value of that currency. That means if the supply of goods and services does not increase or not increases as much as the supply of money, the prices for goods and services will go up.[4] Also when referring to inflation, Purchasing Power Parity plays an important role. PPP is being defined as “An economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power.”[5] PPP states that a nation’s currency and its general price levels are supposed to move in opposite directions.[6] If PPP holds and the differential inflation rates between countries are exactly offset by exchange rate changes, countries’ competitive positions in world export markets will not be systematically affected by exchange rate changes. If there are deviations from PPP, changes in nominal exchange rates cause changes in the real exchange rates which affect the international competitive positions of countries. Consequently this affects countries’ trade balances.[7]

The relative inflation rate affects international trade activity, which influences the demand and supply of foreign currencies. For example if U.S. inflation increases, there will be a higher U.S. demand for British goods and therefore demand for Pound. At the same time there will be a lower British desire for U.S. goods, and hence supply of Pound.[8]

In America a slow in inflation of foreign goods keeps prices of those goods stable. This allows American...
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