Foreign Exchange rates are influenced by several factors in the international market. All tangible factors that is, those which represent quantifiable commercial and personal transactions are captured in the Balance of Payments Account and the net disequilibrium in the BOP represents the single most important demand-supply element affecting an exchange rate. However, 90% of the volume in the foreign exchange market is made of speculative transactions, which are transactions without any underlying commercial base. These transactions are undertaken in anticipation of future changes in demand or supply. Factors which influence the trading decisions of speculators are called intangible factors since their impact cannot be quantified. These factors such as Economic indicators, political changes. Psychological elements etc. which also influence the exchange rate can be summarized as follows:
Gross Domestic Product (GDP)
GDP is the broadest measure of aggregate economic activity in a country and represents the total value of final goods and services produced in a country. GDP is the primary indicator of the strength of economic activity. So, the growth in the GDP positively influences the foreign exchange price of the currency. A fast growing economy will reflect strength in the exchange rate and vise versa.
Trade Balance
This represents the difference between imports and exports of tangible goods. The changes in exports and imports are recorded in the current account of the BOP and therefore have a ready/immediate effect on the demand – supply equation. This data is thus widely followed by the foreign exchange market. A positive BOT would result in an appreciation in the domestic currency which would make imports cheaper and exports costlier and vise versa.
Inflation
Inflation is the rate of change in the price level of a fixed basket of goods and services in an economy. In most countries the most widely followed measure of inflation is the Consumer Price Index (CPI) i.e. the rate of change in the price level of a fixed basket of goods and services purchased by consumers. Inflation reduces the purchasing power of the currency. This reduction in domestic purchasing power gets reflected internationally through depreciation in the exchange rate of the domestic currency.
Employment Levels
Employment levels in an economy reflect the development and stability in the economy. An expanding economy would result in greater investments which would result in more employment generation. This increases income within the economy resulting in higher consumption and savings. This again would mean more investments and the economy would continue in its growth trajectory. Higher employment data therefore reflects a growing economy and leads to appreciation in the domestic currency.
Interest Rate Differentials
Interest rate applicable to a currency has a dual impact on the currency valuation. If increase in the interest rate is a reflection of the strength of the economy then it would have a positive effect on the exchange rate. However if the interest rates increase due to expectations of higher inflation then it would have a negative effect on the value of the currency. In any exchange rate there are two currencies involved. Therefore there are situations when interest rates of both currencies may rise simultaneously. In such situations the interest rate differential is relevant. Sometimes the interest rates of the two currencies could move in opposite directions thereby increasing the gap between the two. In such cases the effect on the exchange rate would be more pronounced.
Exchange Rate Policy
In many countries the exchange rate policy is decided by the Finance Ministry i.e. by the government while monetary policy is decided by the central bank. However, the execution of the exchange rate policy is always managed by the Central Bank. The Central Bank of the country participates in the local foreign exchange market by way of intervention to stabilize the exchange rate or maintain it in a particular range. This also affects the exchange rate of the currency.
Political Factors
The foreign exchange market can be influenced by political events and changes. These events may be anticipated or unforeseen. Some of the common political developments are elections, public announcements by central bank or government officials, military takeovers, political instability, etc. All such factors affect the exchange rate.
View of Speculators
More than 90% of the turnover in international foreign exchange markets represents speculative activity. The view or perception of the likely value of the currency of these participants in the market has a critical effect on the exchange rate.
These are some of the factors that affect the exchange rate but the objective of establishing a precise model for rate determination is a complex task because individual factors work together or in isolation in different proportions at different times.
At the center of this complex environment are the forces of demand and supply that determine the prices of commodities in a free market. In the foreign exchange market, the commodity is the foreign currency. If at any given rate, the demand for a currency is greater than its supply, its price will rise. If supply exceeds demand, the price will fall.
The supply of a nation’s currency is determined by that nation’s monetary authority, which is usually its central bank. Government and central banks closely monitor economic activity to keep money supply at a level appropriate to achieve their economic goals. Too much money increases inflation, causing the value of the currency to decline and prices to rise; whereas too little money would slow economic growth and possibly cause unemployment.
The demand for and supply of a currency ultimately originates with the end users. The governments set monetary policy through their central banks to fulfill the needs of their residents. Banks equalize the supply and demand by trading with each other. The Central Banks ultimately undertake the balancing act between the domestic economy and the external economy represented by the exchange rate and management of reserves.