Causes of changes in the exchange rate
changes in exchange rate
The exchange rate between countries changes due to changes in demand or supply in the foreign exchange market. The factors which cause changes in demand and supply are discoursed as under:
1. Changes in prices.
It is changes in the relative price level that cause changes in the exchange rate. Suppose the price level in Britain rises relative to the united state price level. This will lead to the rise in the prices of British goods in term of pounds. British goods will become dearer in the united state. This will lead to reduction in British exports to the united state. So the supply of dollars to Britain will diminish. On the other hand, the American goods become cheaper in Britain and their imports into Britain increase. So the demand for dollars will increase. Thus the supply curve for dollars will shift to the left so that the exchange rate is established at a higher level from the point of view of the united state. It implies appreciation of the value of the dollar and depreciation of the value of the pounds.
2. Changes in interest rate.
Changes in interest rate also lead to changes in the exchange rate. If interest rates rise in the home country, there is a large inflow of capital from foreign countries. As a result, the exchange rate of the domestic currency will appreciate, relative to the foreign currency. The opposite will be the case, if interest rate falls in the home country.
3. Changes in export and import.
The demand and supply of foreign exchange is also influenced by changes in export and import. If export of country is more than imports, the demand for its currency increases so that the rate of exchange moves in its favor. Conversely, if imports are more than export, the demand for the foreign currency increase and the rate of exchange will move against the country.
4. Capital movement.
Short term or long term capital movement also influence the exchange rate. Capital flows tend to appreciate the value of the currency of the capital importing country and depreciate the value of the currency of the capital exporting country. The exchange rate will move in favor of the capital importing country and against the capital exporting country. The demand for the currency of the capital importing country will rise and its demand curve will shift upward to the exchange rate will be determined at a higher level, given the supply curve of foreign exchange.
5. Influence of bank.
Banks also affect the exchange rate through their operation. They include the purchase and sale of bank drafts, letters of credit, and arbitrage, dealing in bills of exchange, etc. these banking operations influence the demand for and supply of foreign exchange. If the commercial banks issue a large number of drafts and letter of credit on foreign banks, the demand for foreign currency rises.
6. Changes in bank rate.
The bank rate also influences the exchange rate. If the bank rate rises relative to other countries, more funds will flow into the country from abroad to earn high interest rate. It will tend to raise the demand for the domestic currency and the exchange rate will move in favor of the country. Converse will be the case when the bank rate falls.
7. Influence of speculation.
The growth of speculative activities also influences the exchange rate. Speculation causes short run fluctuation in the exchange rate. Uncertainty in the international money market encourages speculation in foreign exchange. If the speculators expect a fall in the value of currency in the near future, they will sell that currency, the supply of the former currency will increase and its exchange rate will fall. While the demand for the other currency will rise and its exchange rate will go up.
8. Stock exchange influence.
Stock exchange operation in foreign securities, debenture, stock and shares, etc. exerts significant influence on the exchange rate. if the stock exchange help in the state securities, debenture, shares etc. to foreigners, the demand for the domestic currency will rise on the part of the foreigners and the exchange rate also tends to rise. The opposite will be the case if the foreigners buy securities, debenture, shares, etc. through the domestic stock exchange.
9. Structural influence.
Structural changes are another important factor which influences the exchange rate of a country. Structural changes are those which bring changes in the consumer demand for commodities. They include technological changes, innovations, etc. which also affect the cost structure along with the demand for products. Such structural changes tend to increase the foreign demand for domestic products. It implies increase in export, greater demand for domestic currency, appreciation of its value and rise in the exchange rate.
10. Political condition.
Stable political and industrial conditions and peace and security in the country have a significant influence on the exchange rate. if there is political stability and the government is stable, strong and efficient, foreigners will have tendency to invest their funds and capital into the country. With the inflow of capital, the demand for domestic currency will rise and the exchange rate will move in favor of the country. On the contrary, if the government is weak, inefficient and dishonest and there is no safety to life and property, capital will flow out of the country and the exchange rate will move against the country.
11. Policies of exchange control and protection.
Policies of exchange control and protection discourage imports and lead to fall in the demand for foreign currency. As a result, the exchange rate of the home country appreciates in relation to the foreign country.
12. Type of economy.
If a country is developing, it needs to import large quantities of raw materials and capital goods for its development along with capital. But its capacity to exports is low Therefore; its demand for foreign exchange is more which leads to the depreciation of its exchange rate vis-Ã -vis developed country whose exchange rate appreciates.
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