Exchange rates are determined by the demand and supply of a particular currency as compared to other currencies. There are numerous factors that determine the exchange rate between two countries. In this article, we will look at some of these factors and see how they affect the exchange rate.
Inflation is one of the major factors that affect the exchange rate. Theoretically a low inflation rate scenario will exhibit a rising currency rate, as the purchasing power of the currency will increase as compared to other currencies. A classic example of this is Yen, the Japanese currency, which has gone through a decade of low inflation and with that the Yen has also appreciated.
Inflation and Interest rates are highly correlated. Higher inflation generally means higher interest rates in an economy. Hence, high interest rate also becomes a factor for the changes in exchange rate. Interest rate is the tool used by the central bank of a country to keep a check on any major currency fluctuation. The central bank can also try to keep the exchange rate under a targeted range by manipulating the interest rates. Higher interest rates bring in more investment from overseas as the returns are higher than countries with low interest rates.
Current Account Deficits:
The current account is the balance of trade between two countries. It reflects all payments and receipts between the two countries for goods, services, interests and dividends. A negative balance of payment or a deficit in the current account shows that the country is importing or spending more on foreign trade than it exporting or earning from abroad. This means that the country requires more foreign currency than it receives from its exports. This excess demand for foreign currency lowers the country’s exchange rate. A good example of this is the deficit balance of payment between US and China. Ideally, due to this increasing deficit in the balance of payment the Dollar should depreciate against the Yuan, however the Chinese government is artificially keeping the exchange rate of Yuan fixed in order to keep its goods cheaper. This kind of fixed exchange rate is called Pegged rate.