Determinants of currency exchange rates

Introduction

Exchange rates are influenced by a wide range of factors in the economy and the importance of each of these factors may vary from one country to another and generally over time. The exchange rate of a country’s level of economic performance. Exchange rates determine the trade activities of a country which is a critical aspect of the free market economy system. Numerous factors do affect the exchange rates in a country but there are only about four major factors.

Inflation rates differentials 

Generally countries with lower inflation rate differentials consistently usually exhibit a rise the value of the currency, as it value appreciates relative to other  world currencies looking at the statistics, countries with low inflation rate over the last decade or so, has exhibited appreciation in their currencies and such economic dominance in the free market system. Inflation rates have an effect of influencing the demand and supply of foreign currencies is high while demand for local, currencies is low. As such pressure in the market will cause depreciation in the local currency relative to the foreign currency.

Balance of payment deficits

When talking about the balance of payments in this case the area of general interest is the current account. Balance of payment. This usually represents the balance of cash inflows and outflows or simply transactions from trade between one country and others. A deficit in the balance of payments account usually represents an excess of cash outflows relative to cash inflows or simply transactions from trade between one country and others. A deficit in the balance of payments account usually represents an excess of cash outflows relative to cash in flows in a country i.e. payments exceed receipts and as a consequence it is required to borrows and to get grants from abroad in order to offset the deficit with capital account surpluses. In simple terms the country is acquiring less foreign currency from demand for foreign currency and thus lowering the value of the local currency. Therefore it’s evidenced that current account deficits do affect the exchange rate.

Terms of trade

Under the law of one price principle, one should be able to purchase commodities in different countries at the same price given that there is a floating exchange rate regime. Therefore an unfavourable increase in the prices of a country exports relative to the imports prices and demand, then, its currency value will decrease in relation to that of its trading partners.

Political stability and economic performance

For investors to put their money into a project in a specific country they have to take into consideration of pointers such as political stability and economic gains in that particular country. If a country such as most third world countries, is faced with political unrests, the investors are very unlikely to bring money into the country into terms of investments. This deprives of a country the much needed cash inflows that essential in affecting the balance of payments problems and subsequently reducing the demand for local currency. On the other hand, economic performance is a key pointer for investors to bring in their money. For a country performing well and interest rates being attractive, a lot of direct cash investment will be brought in. in this case, an increase in supply foreign currency