How Is Exchange Rate Determined. How Important Is the Expected Future Exchange Rate for Exports and Imports?

Topics: Inflation, Currency, Money Pages: 5 (1392 words) Published: July 16, 2013
How is exchange rate determined.
How important is the expected future exchange rate for exports and imports?

1. Introduction

Exchange rate is the price of a currency expressed in another currency, it is one of the most important determinants of a country's relative level of economic health. Exchange rate directly affects the prices of goods in foreign trade and foreign assets prices in the internal market, and indirectly the price of goods for the domestic market. A higher currency makes a country's exports more expensive and imports cheaper in foreign markets; a lower currency makes a country's exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country's balance of trade, while a lower exchange rate would increase it.

2. Determinants of Exchange Rate

There are many factors that directly or indirectly affect the trading of currencies. Each must be considered individually and in relation to the other.

• Inflation and Interest Rates

There exists a strong correlation between interest rates, inflation and exchange rates, so consequently differentials in both these factors will affect the exchange rate.

Generally, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. 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.

Central banks can exert influence over both inflation and exchange rates by manipulating interest rates. 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 limited, but if the inflation rate in the country is much higher than in the others, or if additional factors serve to drive the currency down. As the opposite, lower interest rates tend to reduce exchange rates.

• Current Account Deficits

The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. 

• Public Debt

Nations with large public deficits and debts are less attractive to foreign investors. A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future. The government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating is a crucial determinant of its exchange rate.

• Foreign exchange reserves

The high level of foreign exchange reserves in the country can stabilize the...
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