There is a multitude of factors which come into play when exchange rates are being determined. There are three methods of determining the exchange rate. These are —. Non -intervention: currency in a floating rate world — Currencies that float freely respond to supply and demand conditions tree govt. Demand for a countries currency is a function of the demand for those countries goods and services and financial assets. Intervention — Currency is a fixed rate or managed the floating world.
A govt. The role of the central banks-each country has a central bank responsible for the policies affecting the value of its currency. Exchange rates are basically a comparison between the policies of two countries.
It is essential to understand that exchange rates are not absolute rather they are relative. The following factors are considered amidst many others while comparing the monetary policies of any two countries. Inflation: Exchange rate is basically a ratio between the expected number of units of one currency and the expected number of units of other currency in the market.
Inflation increases the number of currency units. Hence, inflation rates are a major factor while determining exchange rates. However, the official inflation rates often do not tell the true picture. Therefore, participants of the market use their own estimates of inflation rate and come up with their own valuations for currency pairs. Interest Rates: When investors hold a certain currency, they get a yield in terms of the interest rate that is applicable on that currency. Therefore, the interest rate yields are also priced into the Forex rates that are quoted in the market.
The currency valuations are extremely subjective to interest rate changes. A small change in this rate brings about a big reaction from the market participants.
Therefore, Central Banks become extremely important participants in the Forex market since they control the monetary policy which is one of the biggest determinants of the value of the currency.
While monetary policy is controlled by the Central Bank of the country, the fiscal policy is controlled by the government. The government or central bank will attempt to implement measures to move their currency to a more favorable price. More macro factors also affect exchange rates. The ' Law of One Price ' dictates that in a world of international trade, the price of a good in one country should equal the price in another.
This is called purchasing price parity PPP. If prices get out of whack, the interest rates in a country will shift—or else the exchange rate will between currencies. Of course, reality doesn't always follow economic theory, and due to several mitigating factors, the law of one price does not often hold in practice. Still, interest rates and relative prices will influence exchange rates. Another macro factor is the geopolitical risk and the stability of a country's government.
If the government is not stable, the currency in that country is likely to fall in value relative to more developed, stable nations.
Generally, the more dependent a country is on a primary domestic industry, the stronger the correlation between the national currency and the industry's commodity prices. There is no uniform rule for determining what commodities a given currency will be correlated with and how strong that correlation will be. However, some currencies provide good examples of commodity- forex relationships.
Consider that the Canadian dollar is positively correlated to the price of oil. Therefore, as the price of oil goes up, the Canadian dollar tends to appreciate against other major currencies. This is because Canada is a net oil exporter; when oil prices are high, Canada tends to reap greater revenues from its oil exports giving the Canadian dollar a boost on the foreign exchange market. Another good example is the Australian dollar, which is positively correlated with gold.
Because Australia is one of the world's biggest gold producers, its dollar tends to move in unison with price changes in gold bullion. Thus, when gold prices rise significantly, the Australian dollar will also be expected to appreciate against other major currencies. Some countries may decide to use a pegged exchange rate that is set and maintained artificially by the government.
This rate will not fluctuate intraday and may be reset on particular dates known as revaluation dates. Governments of emerging market countries often do this to create stability in the value of their currencies. To keep the pegged foreign exchange rate stable, the government of the country must hold large reserves of the currency to which its currency is pegged to control changes in supply and demand.
Federal Reserve Bank of New York. Foreign Exchange Intervention. International Monetary Fund. European Journal of Political Economy. Accessed Mar. Generally, countries with mature, stable economic markets will use a floating system.
Virtually every major nation uses this system, including the U. Floating exchange rates are considered more efficient, because the market will automatically correct the rate to reflect inflation and other economic forces. The floating system isn't perfect, though. If a country's economy suffers from instability, a floating system will discourage investment.
Investors could fall victim to wild swings in the exchange rates, as well as disastrous inflation. You can see a floating system at work. Changes in the U. For years, a Canadian dollar was worth about 65 cents. In , it rose to 75 cents.
By early , it had reached about 92 cents. Look in the business section of your newspaper, or check an exchange rate calculator on the Internet , and track the Canadian dollar's rise in value yourself. Right now, economists aren't sure how high it will go.
A pegged, or fixed system , is one in which the exchange rate is set and artificially maintained by the government. The rate will be pegged to some other country's dollar, usually the U. The rate will not fluctuate from day to day. A government has to work to keep their pegged rate stable. Their national bank must hold large reserves of foreign currency to mitigate changes in supply and demand.
If a sudden demand for a currency were to drive up the exchange rate, the national bank would have to release enough of that currency into the market to meet the demand. They can also buy up currency if low demand is lowering exchange rates. Countries that have immature, potentially unstable economies usually use a pegged system.
Developing nations can use this system to prevent out-of control-inflation. The system can backfire, however, if the real world market value of the currency is not reflected by the pegged rate.
In that case, a black market may spring up, where the currency will be traded at its market value, disregarding the government's peg. When people realize that their currency isn't worth as much as the pegged rate indicates, they may rush to exchange their money for other, more stable currencies.
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