Exchange rate is the price of one currency in terms of another currency. In other words, it is the rate at which two currencies can be exchanged. There are several factors which affect and decide the exchange rate of currencies, causing frequent fluctuations in the rate. Sometimes the exchange rate may change over a period of some months or years and sometimes fluctuations occur within a span of some hours and days.
Theoretically, in a free market, the rate of exchange is determined by the demand for and supply of foreign currency. The equilibrium rate of exchange is attained at the point where demand for foreign currency is exactly equal to it’s supply. The demand and supply of foreign currency arise from international trade, investments and other international transactions. For example- If India imports some goods from the US, India will require US dollars to pay for those imports. This is demand for dollars and supply of Rupees in exchange, in the foreign exchange market. India will buy dollars against Rupees to pay for its imports. Whereas, if India exports some goods or services to the US, there will be a demand for Indian Rupees by the US to pay for its imports from India.
This is basic economics, that demand and supply keep adjusting till they become equal and the equilibrium rate is achieved. But this ideal equilibrium rate is difficult to achieve because demand and supply are affected by several factors, which cause frequent fluctuations and adjustments in the exchange rate, fixing it at a rate which may not be the equilibrium rate.
Factors influencing the rate of exchange-
1. International trade- Trade of goods and services between countries is the major reason for the demand and supply of foreign currencies. The value or strength or weakness of a countries currency in terms of other currencies depends on its trade with those countries. If a country’s imports are higher, the demand for foreign currency in this country will be high. Higher demand for foreign currency means high value of foreign currency and low value of the domestic currency. This is a typical case for underdeveloped countries which rely on imports for development needs. The current account balance (deficit or surplus) thus reflects the strength and weakness of the domestic currency.
2. Capital movements- International investments in the form of Foreign direct investment (FDI) and Foreign institutional investments (FII) have become the most important factors affecting the exchange rate in today’s open world economy. Countries which attract large capital inflows through foreign investments, will witness an appreciation in its domestic currency as its demand rises. Outflow of capital would mean a depreciation of domestic currency.
3. Change in prices- Domestic inflation or deflation affects the exchange rate by affecting the demand and supply of domestic currency in the foreign exchange market. For example, if prices in India go up, making Indian goods costlier, the demand for Indian goods will do down. When exports go down, the demand for rupee will fall, causing depreciation in its exchange value.
4. Speculations- Uncertainties are always there in the financial market. Speculators predict about the future exchange rate based on various happenings in the world, in various countries. Speculators study the various ups and downs of a country and its resilience to international happenings and forecast the possible future exchange rate based on a particular countries economic strengths and weaknesses. If the speculators expect a fall in the value of a currency in the near future, they will sell that currency and start buying the other currency that they expect to appreciate. The selling of the former currency will thus increase its supply in the foreign exchange market and bring down its value. The other currency appreciates as its demand increases.
5. Strength of the economy- If the economic fundamentals of a country are strong, the exchange rate of its domestic currency remains stable and strong. Fiscal balance, international current account balance, international liabilities, foreign exchange reserves, resilience to international trade fluctuations, GDP, inflation rate all are indicators of a country’s economic strength.
6. Government policies- In countries where there is fixed or managed float, the central bank becomes an important player in the foreign exchange market. The bank influences the value of the currency by its market operations like buying and selling of bills and currencies. The bank rate also influences the exchange rate by influencing investments and thereby the demand and supply of the domestic currency.
7. Stock exchange operations- Stock exchange operations in foreign securities, debentures, stocks and shares, influence the demand and supply of related currencies, thus influencing their exchange rate.
8. Political factors- Political scenario of the country ultimately decides the strength of the country. Stable efficient government at the centre will encourage positive development in the country, creating successful-investors/”title=”investor ” >investor confidence and a good image in the international market. An economy with a strong, positive image will obviously have a strong domestic currency. This is the reason why speculations rise considerably during the parliament elections, with various predictions of the future government and its policies. In 1998, the Indian rupee depreciated against the dollar due to the American sanctions after India conducted the Pokharan nuclear test.
Value of a currency is thus not a simple result of its demand and supply, but a complex mix of multiple factors influencing the demand and supply. It’s a tight rope walk for any country to maintain a strong, stable currency, with policies taking care of conflicting demands like inflation and export promotion, welcoming foreign investments and avoiding an appreciation of the domestic currency, all at the same time.