DETERMINANTS OF EXCHANGE RATES
trading is a global phenomenon and is the order of the day which always calls
for more effective ways for better analysis of movements. Currency exchange
rates play an important role in international trading and investment and its
highly uncertain and unpredicted instrument and can cause confusion if proper
care is not taken. People have already used Currency futures as an investment
option and they can trade various currencies as per the current economic
conditions of the country. The purpose of this research is to find the main
factors which are influencing currency rates and the empirical evidence to
support my arguments.
Front Sheet ………………………………………….
meaning of exchange rates………………………………..
of Exchange Rates………………………………………….
of Exchange Rates:
1. In the short run……………………………………………….
2. In the long run…………………………………………………
Currency trading is a
global phenomenon and is the order of the day which always calls for more
effective ways for better analysis of movements. Currency exchange rates play
an important role in international trading and investment and is highly
uncertain and unpredicted instrument and can cause confusion if proper care is
not taken. People have already used Currency futures as an investment options
and they can trade various currencies as per the current economic conditions of
the country. The purpose of this research is to find the main factors which are
influencing currency rates and the empirical evidence to support my arguments
The exchange rate can be
defined as the number of unit of a domestic currency which can be used to buy
one unit of foreign currency. Thus, the exchange rate at which one currency can
be exchanged for other currencies. It is very important because it allows the
conversion of domestic currency into a foreign currency, thus it facilitate
international trade amongst countries (Abdoh et al, 2016). The determinants of
exchange rate regime choice have been extensively analysed by both theoretical
and empirical studies. Some of these studies have found systematic
relationship. Due to different results obtained by different empirical studies,
it is therefore, difficult to make simple generalisation about how countries
choose their exchange rate regimes. After the Bretton Woods system, many
countries resort to floating rates and empirical studies on the determinants of
exchange rate regimes have been abundant. Under the Bretton Wood system, a
decrease in the demand for the export of a country can lead to a decrease in
the GDP. However, the collapse of the Bretton Woods system gave rise to a
flexible exchange rate system which protects a country from adverse economic
shock. The most controversial features of this flexible rate are their high
volatility. The latter being the extent to which one variable changes over a
period of time (Mirchandani, 2013).
In this assignment, the
reader will have a view of the various types of exchange rates, the roles of
exchange rates and the factors that determine the exchange rate. Care will be
taken in employing empirical evidence for the proper understanding of the
factors. From my own research, the factors that determine exchange rates are Inflation
Rates, Interest Rates, Country’s current account of Balance of Payments,
Government Debts, Terms of Trade, Political Stability and Performance,
Recession and Speculation.
INFLUENCING EXCHANGE RATES
In this section I will
emphasis on the various factors affecting currency movements and their
characteristics. According to Madura and Fox (2011), the major factors that
influence exchange rates are Inflation, Interest rates, relative Income levels,
Government controls and expectations in future exchange rates.
1. INFLATION RATES
Exchange rate has a
close significance in international trade and is a monetary policy framework in
emerging economies. It is therefore no more a new issue but at the moment it is
a hot topic for debates. Following the exit of Bretton Woods from fixed to
flexible exchange rate regimes and inflation targeting, the role of exchange
rate in international monetary policy cannot be ignored. Many emerging
economies according to Kun et al (2012), have their debts denominated in U.S.
dollar. Thus, large fluctuations in exchange rate will have a repercussion on
their balance sheet stability. When their foreign debts increase, these
countries feel reluctant to float the exchange rate freely.
Inflation, which is
rising prices may be one of the factors determining exchange rates while it may
be the factor affected by exchange rates. We shall confine on the pass- through
effect of exchange rates on domestic prices as suggested by Abdurehman and
Hacilar (2016). On their research on a large data set of 71 countries for the
years 1979-2000, Choulri and Hakura (2001) found a pass through from exchange
rates to prices. Their findings which was in consistent with Taylor (2000),
indicated that, the pass-through get higher for countries with higher inflation
which means that “higher inflation higher pass through”.
Nelson and Kara (2002)
has pointed out that there has been a thorough discussion of the exchange rate
and inflation in UK monetary policy from 1990. Chancellor Lamont announcing the
details of the new inflation targeting in 1992 stated that ‘Some people insist
that movements in the exchange rate are just a change in relative prices which
need not affect the rate of inflation. Others argue more pragmatically that
disinflationary forces are currently so strong, thus such pressures pose no
threat. I am not persuaded by either of these arguments’ (Lamont, 1992, p. 24).
The Bank of England’s Inflation Report of February 1994 maintained that ‘UK import
prices would be expected to change one-for-one with any change with any change
in the exchange rate (BOE, 1994).
1; Impact of rising US inflation on the equilibrium value of US dollar
When market inflation
changes, this can cause changes in currency exchange rates. Thus, a country
with a lower inflation rate than another’s will see an appreciation in the
value of its currency. An extract from OECD (2017) below indicates that the
rate of inflation in the US has been rising at a faster rate than in Germany
whose inflation even declined in October this year as in Table 1.
1: INFLATION (CPI) (Extract 2017 in percentages)
which has a lower inflationary rate will see an appreciation in the value of
its currency with US. In Germany, the prices of goods and services increases at
a slower rate. The influence of inflation on exchange rate is quite clear. If
the rate of inflation in Germany is lower than in US, the German exports will
increase. There will be an increase in demand for Euros to buy German goods.
Also, US goods become cheaper and so Germans will pay less which can decrease
imports and therefore, giving a favourable balance of trade.
2. INTEREST RATES
bring us to the fact that interest rate is the price of money and is also
considered as the supply and demand for money. In this regard, we consider how
interest rate affect exchange rate. It is also important to note that since FDI
cause free movement of capital from a country to another, UK interest rates are
closely linked to those of US, Europe and Japan. In the UK, an open economy,
the link between interest rates and exchange rate is stronger than the link
between interest rates and money supply.
This script is to
correct the misconception that a negative correlation between the price of
foreign currency and nominal interest rates is an evidence in the real interest
rate. Am example is given by Jacob Frenkel (1979) who stated that ‘By and
large, since the latter part of 1979, the high nominal rate of interest in the
US is as a result of an appreciation of the dollar. This suggests that the
important factor underlying the evolution of the nominal rate of interest in
the US has been the emergence of the real rate of interest rather than the
inflationary expectations.’ Jeffrey Frankel, in 1979, indicated that there is a
positive relation between interest rates and exchange rates.
According to the
Financial Times (November 2017), for the first time in six years, The Bank of
Korea has increased its interest rates from 1.25% to 1.5%. This was to trigger
a policy tightening cycle on the back of the country’s export-driven economic
recovery (Jung-a, 2017). Thus, the country exports have been boosted by the
global demand for its chips, steel and petrochemical products.
investment flows are very large in the international monetary markets, interest
rates is considered to be an important factor in determining exchange rates. Normally
foreign investors rely on interest rates as a deciding factor. Thus, the high
interest rate in South Korea will attract more investors. On the other hand,
countries with a low interest rates can deter the presence of foreign
investors. Many economics gurus argue that high interest rates cannot be the
only factor to determine the value of a currency. They argue that although the
interest rate is higher, there could be offsetting fall in the value of the
currency with the high interest rates. Supposing in the UK, LIBOR is set at 7%
and in the US the rate is set at 5%. This high interest rate in the UK, some
economist argue that it may not attract US investors with the view that they’re
expecting the British pound to lose its value by 2% (7% – 5% = 2%). According
to this calculation, there is a 2% loss in the value of the pound. So a higher
interest rate would not attract all international investments because a good
number of them will think that there is likely to be an even greater offsetting
fall in the pound. However, from all indications if interest rates go up,
prices, and hence exchange rates, should rise.
A change in income
levels in UK can change the amount of imports demanded and therefore the
exchange rates. If the income level of UK rises, Germany income levels will
remain the same and therefore, the following deductions can be made;
a. the demand schedule for euros will shift
outward reflecting the increase in UK income and therefore increase demand for
b. the supply schedule for euros for sale will
c. exchange rate of euros will rise.
£0.725 D1 D2
Quantity of euros
the diagram the equilibrium exchange rate will increase from £0.800 to £0.825.
thus the value of euros is expected to rise. According to Madura and Fox
(2011), changing in income levels of a country can indirectly affect their
interest rates, this may be quite different from the explanation above.
4. Government Controls
the Central Bank Intervention can be used to boost or decrease their country’s
currency value. They do that for the purpose of boosting and decreasing
productivity and their exports. This action has been flawed but the banks do
that to safeguard their currency against an alternative currency. In the case
of a country’s currency undergoing unnecessary upward and downward financial
pressure, the central bank will use the Forex market intervention to stabilise
her currency. The central banks action in controlling the exchange rate is
always in line with the categories below; Fixed, Managed Float, Pegged and
Freely floating (Madura and Fox, 2011). During the Bretton Woods era from 1944
to 1971, the exchange rate was fixed in terms of gold. The Smithsonian
Agreement of 1971 saw the devaluation of dollar by 8% and raising the price of
gold from $35 to $38. In a managed floating exchange rate system, the exchange
rates are allowed to move freely on a daily basis without the existence of
official boundaries. However, government may intervene to prevent the rates
from moving too high just for the benefit of its own country. It should be
noted that from 1972 to 1979, the European Economic Community pegged the
currencies of its member countries within established limits of each country.
In 1994, the Mexico central bank pegged the peso to the US dollar but there was
a limit. In some countries, Currency Boards are responsible in maintaining the
value of their currency in respect to other specified currency. Since 1983,
Hong Kong has tied its value of the dollar to that of US by HK$7.8 to $1.
Similarly, from 1991, Argentina has tied the value of the peso to the US dollar
by 1 peso to $1. It should be noted that the value of a pegged currency does
not conform to the laws of demand and supply conditions in the foreign exchange
markets and may result in uneven trade. Some countries have implemented
dollarization which replaces their local currencies with the US dollar. Since
2000, Ecuador has implemented dollarization.
country has a government representative that intervene in the foreign exchange
markets. In the US and the UK, the Federal Reserves and the Bank of England are
responsible for such actions. The manage the exchange rates to smooth exchange
rates movements and respond to temporary disturbances. This is much explained
in the figure below. When Central Banks intervenes in the foreign exchange
markets without taking care of the money supply, it is said to engage in
non-sterilised intervention. In other to maintain the money supply, sterilised
intervention is said to take place. Restriction on currency exchange is a form
of indirect intervention which is sometimes used by some governments.
action by the government in 1992 to curb the high exchange rate was in a fiasco.
The pound was in the European Exchange Rate Mechanism (ERM) but struggled to
keep its value against the Deutschmark (DM). In the exchange rate mechanism,
the pound sterling fell to its lower limit. The government, in response to this
situation, raised the interest rates to 15% and bought pound sterling on the
foreign currency reserves. The situation was not sufficient and therefore, gave
into the market pressure and called it a quit to the ERM. The 15% interest
rates rise was disastrous.
of changes in exchange rates are normally used by the banks and brokers. If a
country’s currency is expected to increase in value, investors will demand more
of the of that currency in order to make profit in the near future. On such
occurrences due to high demand the value of the currency will rise which will
call for an increase in exchange rate.
should be noted that speculation attack on a currency occurs when investors
believe that the value of a currency is overvalued and therefore they sell that
currency in anticipation of it falling and buy another currency. Such
transactions bring profits (Pettinger, 2014). Katrina Turrill (June 2017), in
her article on pound to euro exchange rate, she notified the public how the
Governor of the BoE suggested a rise in interest rate as a result of the rising
pound. The pound to euro conversion rate which is currently at €1.138 has
witnessed highs of €1.140 and lows of €1.126. the day before the pound was
standing at €1.136. The Governor indicated that interest rate hike speculation
is responsible for the sterling jumping against the euro and other major
government may try to keep the value of an exchange rate within certain bands
such as fixing the pounds between $1.4 and $1.7. if the currency went below
this level, the government would intervene to protect the falling value of the
pound. The would either increase interest rates or buy sterling with foreign
currencies. The idea is to let people not speculating on the currency. However,
the fixed exchange rate should not prevent you to speculate if the fixed
exchange rate does not reflect the underlying market conditions. When the UK
joined the ERM, because of recession, speculators thought the pound was too
strong, so they sold and later on UK was forced to leave the Exchange Rate
Mechanism. The action of speculators worsened UK economic situation (Pettinger,
2008). This is indicated in the diagram below.
6. GOVERNMENT DEBTS
is one of the minor factors which is responsible for exchange rates changes. Government
debts is public debts or national debts owned by the government. With a huge
government debt, the country is less likely to acquire foreign capital and
therefore, inflation has to take its position. Thus, foreign investors will
sell their bonds and will lead to a decrease in the value of the exchange rate.
According to Lin (1994), other things being equal, an increase in government
debts depreciates the real exchange rate of the country. In a steady state, an
increase in government debts will lead to an increase in taxes so as to offset
the debts. However, an increase in taxes will lower disposable income and
therefore lowers domestic savings leading the exchange rate to decrease.
7. POLITICAL STABILITY
minor factor hovering around exchange rate
is political stability. Evidence is there for the fact that political economy
factor is responsible in determining exchange rate regime. Studies in
developing countries has revealed by Collins (1996) and Edwards (1996) who use
probit analysis to study the determinants of exchange rate regime. They build
their empirical models around a framework in which the political cost
associated with devaluation under fixed exchange rate plays an important role.
Thus, a country political state and economic performance can affect its
currency strength. A country with less risk of political turmoil can attract
foreign investors. There will be an increase in foreign capital which can lead
to an an appreciation in the value of the domestic currency. However, a country
which is prone to political confusion may witness a depreciation in the
minor factor determining exchange rate is recession. As soon as a country
experiences recession, its interest rates fall which can decrease its chances
of acquiring foreign capital. This can weaken its currency comparatively and
therefore lowers its exchange rate. However, it should be noted that there is
no hard and fast rule on exchange rate during recession. During the recession
of 2008, the sterling depreciated by almost 25% but US dollar was not affected
much, the dollar fluctuated. This can be seen in the diagram below.