Exchange Rate Determinants


Financial managers of multinational companies constantly monitor exchange rates because their cash flows are highly dependent on exchange rates. As economic conditions change, exchange rates can change dramatically and negatively affect the value of the business. Here we will review some of the factors that influence exchange rates.

The first factor is the rate of inflation. Fluctuations in inflation rates can affect the activity of international trade, which influences the demand for and supply of foreign exchange and, consequently, exchange rates. For example, a higher inflation rate in the UK compared to other countries will tend to reduce the value of the British pound as the prices of goods and services in the UK increase to a higher level. comparatively faster pace. These goods and services then appear more expensive to foreigners, which reduces the demand for British exports. As a result, demand for sterling will be lower. In addition, UK consumers will find it more interesting to buy European imports. Therefore, they will provide books to be able to buy euros and imports in euros. This increase in the supply of pounds decreases the value of the pound sterling.

The second factor is the interest rates. Changes in relative interest rates affect investments in foreign securities, which affect the demand for and supply of foreign exchange and, consequently, exchange rates. Investors will invest their funds where, for a given level of risk, returns are the highest. Thus, if there is a difference in interest rates between countries with the same default risk, investors would likely make loans to the country with the highest interest rate. To invest or lend in another country, you must first get the currency of this country. This increases the demand for the currency of this nation and makes it gain value.

A third factor that influences exchange rates is the level of relative income. As revenues may affect the amount of imports requested, they may also affect exchange rates. Suppose that the level of American income increases considerably while the British income level remains unchanged. In this scenario, the demand for books will increase, because of the increase in US income and therefore the increased demand for British products. Second, the supply of books for sale should not change. As a result, the exchange rate of the pound sterling should increase.

A fourth factor affecting exchange rates is government control. Foreign governments can influence the balance rate in several ways, including:

(1) impose exchange barriers,

(2) the imposition of barriers to foreign trade,

(3) intervening (buying and selling foreign currency) on the foreign exchange markets and

(4) affecting macro variables such as inflation, interest rates and income levels.

Other important factors are political and economic factors. Most investors are not inclined to take risks. They will invest their funds where there is a certain level of certainty. They tend to avoid investing in countries characterized by government instability and / or economic stagnation. On the other hand, they will invest capital in stable countries with strong signs of economic growth. A country whose government and economy are stable in a sustainable way will attract the most investment. This, in turn, creates a demand for the currency of this country and leads to an appreciation of its currency.

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