Factors That Influence Exchange Rates Essay Example for Free

Factors That Influence Exchange Rates EssayAside from factors a great deal(prenominal) as involution rate and inflation, the permute rate is one of the most important determinants of a hoidenishs relative level of economic health. Exchange grade cinch a vital role in a countrys level of trade, which is critical to most every free market economy in the world. For this reason, exchange rate ar among the most watched, analyzed and governmentally manipulated economic measures. But exchange rates matter on a smaller scale as intimately they continue the real return of an investors portfolio. Here we look at some of the major forces behind exchange rate movements. A higher property makes a countrys exports to a greater extent expensive and imports cheaper in unconnected markets a lower currency makes a countrys exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the countrys labyrinthine sense of trade, while a lower exchange rate would increase it.Determinants of Exchange Rates legion(predicate) factors determine exchange rates, and all are related to the trading relationship between two countries. Remember, exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries. Note that these factors are in no particular order like many aspects of economics, the relative importance of these factors is subject to much debate. 1. Differentials in Inflation-As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing world-beater increases relative to other currencies. During the last half of the ordinal 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 deprec iation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates.2. Differentials in 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 slayer 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.3. Current-Account Deficits-The current account is the balance of trade between a countr y 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 quest for its products. The excess demand for foreign currency lowers the countrys exchange rate until internal goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for national interests.4. Public Debt-Countries result engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large de bt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future. In the worst case scenario, a government may print money to pay part of a large debt, except change magnitude 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 countrys debt rating (as determined by Moodys or step Poors, for example) is a crucial determinant of its exchange rate. 5. Terms of Trade-A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a countrys exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the countrys exports. This, in turn, results in rising revenues from exports, which provides increased demand for the countrys currency (and an increase in the currencys value). If the price of exports rises by a smaller rate than that of its imports, the currencys value will decrease in relation to its trading partners.6. Political Stability and Economic Performance-Foreign investors inevitably seek out stable countries with strong economic murder in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currenc ies of more stable countries.ConclusionThe exchange rate of the currency in which a portfolio holds the bulk of its investments determines that portfolios real return. A declining exchange rate obviously decreases the purchasing power of income and capital gains derived from any returns. Moreover, the exchange rate influences other income factors such as interest rates, inflation and even capital gains from domestic securities. While exchange rates are determined by numerous complex factors that often leave even the most experienced economists flummoxed, investors should still have some understanding of how currency values and exchange rates play an important role in the rate of return on their investments.