When trade takes place between the residents of two countries, the two countries being a sovereign state have their own set of regulations and currency. The exporter would like to get the payment in the currency of his own country, the importer can pay only in the currency of the importers country. This creates a need for the conversion of the currency of importer’s into that of the exporter’s country. Foreign exchange is the mechanism by which the currency of one country is gets converted into the currency of another country. The conversion is done by banks and financial institutions, who deals with foreign exchange business.
When one currency is converted into another, there must be some basis in effecting the conversion. The basis by which the currency unit of one country gets converted into currency units of another country is known as foreign exchange rate. Foreign exchange rate is therefore the price of one currency in terms of another. The rate of exchange for a currency is known from the quotation in the foreign exchange market.
Factors Affecting Exchange Rates
In the globalized economic environment of today, economic activity is globally unified to an unprecedented degree. Thus, changes in one nation’s economy are rapidly transmitted to that nation’s trading partners. These fluctuations in economic activity are reflected, almost immediately as fluctuations in currency values.
Some of the important factors that influence currency values are balance of payments, inflation rates and interest rates.
- Balance of Payments: The balance of payments summarizes the flow of economic transactions between residents of a given country and the residents of other countries during a certain period of time. Balance of payments represents the demand and supply of foreign exchange which ultimately determine the value of the currency. When the balance of payments of a country is continuously deficit, it implies that the demand for the currency of the country is lesser than its supply. Therefore, its value in the market declines. If the balance of payments is surplus continuously, it shows that the demand for the currency in the exchange market is higher than its supply and therefore the currency gains value.
- Relative Inflation Rates: Suppose that the supply of dollars increases relative to its demand. This excess growth in the money supply in an economy will cause inflation. This inflation causes the weakening of nations currency. For example, higher prices in the United States will lead American consumers to substitute French imports for U.S. products, resulting in an increase in the demand for euros. In effect both French and Americans are searching for the best deals worldwide and will switch their purchases accordingly. Hence a higher rate of inflation in the United States than in France will simultaneously increase French exports to the United States and reduce U.S. exports to France. In other words a higher rate of inflation in the United States than in France will lead to depreciation of the depreciation of the dollar relative to the euro or, to an appreciation of the euro relative to the dollar. In general, a nation running a relatively high rate of inflation will find its currency declining in value relative to the currencies of countries with lower inflation rates.
- Relative Interest rates: Interest rate differentials will also affect the equilibrium exchange rate. For example, a rise in US interest rates relative to Indian rates all else being equal, will cause investors in both nations to switch from Rupee to dollar-denominated securities to take advantage of the higher dollar rates. The net result will be depreciation of the Rupee in the absence of government intervention. It should be noted that the interest rates discussed here are real interest rates. The real interest rate equals the nominal or actual interest rate minus the rate of inflation. The distinction between nominal and real interest rates is critical in international finance. If the increase in U.S. rates relative to Indian rates just reflects higher U.S. inflation, the predicted result will be a weaker dollar. Only an increase in the real U.S. rate relative to the real Indian rate will result in an appreciating dollar.