PROJECT REPORT ON

Factors Influencing Exchange Rates

UNIVERSITY OF MUMBAI

MASTER OF COMMERCE

(Banking & Finance)

SEMESTER III

2016-17

SUBMITTED BY

Name: Samriddhi Rakhecha

Roll No.: 16

PROJECT GUIDE

Ms. Shital Mody

K.P.B HINDUJA COLLEGE OF COMMERCE

1
 315, NEW CHARNI ROAD, MUMBAI-400 004

M.Com (Banking & Finance)

3rd SEMESTER

Factors Influencing Exchange Rates

SUBMITTED BY

Samriddhi Rakhecha

Roll No.: 16

2
 Smt. P.D. Hinduja Trusts

K.P.B. HINDUJA COLLEGE OF COMMERCE

315, New Charni Road, Mumbai 400 004 Tel.: 022- 40989000 Fax: 2385 93 97. Email:

NAAC Re-Accredited A
O 9001:2008THE BEST COLLEGE OF UNIVERSITY OF MUMBAI FOR THE ACADEMIC YEAR 2010
Prin. Dr. Minu Madlani (M. Com., Ph. D.)

CERTIFICATE

This is to certify that Ms. Samriddhi Rakhecha of M.Com (Banking &

Finance) Semester 3rd [2016-2017] has successfully completed the

Project on Factors Influencing Exchange Rates under the guidance of

DR. KULDEEP SHARMA.

________________ ________________
Project Guide Co-coordinator

________________ ________________

Internal Examiner External Examiner

3
________________ ________________
Principal College Seal

DECLARATION

I Mr. / Ms. Samriddhi Rakhecha, student of M.Com-Banking &

Finance, 3rd semester (2016-2017), hereby declare that I have completed
the project on Factors Influencing Exchange Rates

The information submitted is true and original copy to the best of

our knowledge.

(Signature)

Student

4
5
Contents

Chapter Topic Page No.

Introduction to Foreign Exchange
1.1 Markets 6
1.2 History of Foreign Exchange 8
1.3 Objective of the Study 12
1.4 Scope of the Study 12
1.5 Need for Foreign Exchange 13
2.1 Review of the Literature 15
3.1 What is the Foreign Exchange Rate? 18
3.2 Types of Foreign Exchange Rates 20
3.3 Theories of Exchange Rate 21
Classification of Factors affecting
4.1 Exchange Rate Levels 23
Factors influencing Foreign Exchange
4.2 Rates 25
Consequences of Exchange Rate
4.3 Fluctuations 33
5 Conclusion 34
6 Bibliography 35

6
Chapter 1.1: Introduction to Foreign Exchange Market
The foreign exchange market (forex, FX, or currency market) is a
global decentralized market for the trading of currencies. This includes all
aspects of buying, selling and exchanging currencies at current or
determined prices. In terms of volume of trading, it is by far the largest
market in the world. The main participants in this market are the larger
international banks. Financial centres around the world function as
anchors of trading between a wide range of multiple types of buyers and
sellers around the clock, with the exception of weekends. The foreign
exchange market does not determine the relative values of different
currencies, but sets the current market price of the value of one currency
as demanded against another.
The foreign exchange market works through financial institutions, and it
operates on several levels. Behind the scenes banks turn to a smaller
number of financial firms known as "dealers", who are actively involved
in large quantities of foreign exchange trading. Most foreign exchange
dealers are banks, so this behind-the-scenes market is sometimes called
the "interbank market", although a few insurance companies and other
kinds of financial firms are involved. Trades between foreign exchange
dealers can be very large, involving hundreds of millions of dollars.
Because of the sovereignty issue when involving two currencies, forex
has little (if any) supervisory entity regulating its actions.
The foreign exchange market assists international trade and investments
by enabling currency conversion. For example, it permits a business in
the United States to import goods from European Union member states,
especially Eurozone members, and pay Euros, even though its income is
in United States dollars. It also supports direct speculation and evaluation
relative to the value of currencies, and the carry trade, speculation based
on the interest rate differential between two currencies.
In a typical foreign exchange transaction, a party purchases some quantity
of one currency by paying with some quantity of another currency. The
modern foreign exchange market began forming during the 1970s after
three decades of government restrictions on foreign exchange transactions

7
(the Bretton Woods system of monetary management established the rules
for commercial and financial relations among the world's major industrial
states after World War II), when countries gradually switched to floating
exchange rates from the previous exchange rate regime, which
remained fixed as per the Bretton Woods system.

8
Chapter 1.2: History of Foreign Exchange
Gold Standard System
The creation of the gold standard monetary system in 1875 is one of the
most important events in the history of the forex market. Before the gold
standard was created, countries would commonly use gold and silver as
method of international payment. The main issue with using gold and
silver for payment is that the value of these metals is greatly affected by
global supply and demand. For example, the discovery of a new gold
mine would drive gold prices down. (For background reading, see The
Gold Standard Revisited.)

The basic idea behind the gold standard was that governments guaranteed
the conversion of currency into a specific amount of gold, and vice versa.
In other words, a currency was backed by gold. Obviously, governments
needed a fairly substantial gold reserve in order to meet the demand for
currency exchanges. During the late nineteenth century, all of the major
economic countries had pegged an amount of currency to an ounce of
gold. Over time, the difference in price of an ounce of gold between two
currencies became the exchange rate for those two currencies. This
represented the first official means of currency exchange in history.

The gold standard eventually broke down during the beginning of World
War I. Due to the political tension with Germany, the major European
powers felt a need to complete large military projects, so they began
printing more money to help pay for these projects. The financial burden
of these projects was so substantial that there was not enough gold at the
time to exchange for all the extra currency that the governments were
printing off.

Although the gold standard would make a small comeback during the
years between the wars, most countries had dropped it again by the onset
of World War II. However, gold never stopped being the ultimate form of
monetary value. (For more on this, read What Is Wrong With
Gold? and Using Technical Analysis In The Gold Markets.)
9
Bretton Woods System
Before the end of World War II, the Allied nations felt the need to set up a
monetary system in order to fill the void that was left when the gold
standard system was abandoned. In July 1944, more than 700
representatives from the Allies met in Bretton Woods, New Hampshire, to
deliberate over what would be called theBretton Woods system of
international monetary management.

To simplify, Bretton Woods led to the formation of the following:

A method of fixed exchange rates;

The U.S. dollar replacing the gold standard to become a

primary reserve currency; and

The creation of three international agencies to oversee economic

activity: the International Monetary Fund (IMF), International Bank
for Reconstruction and Development, and the General Agreement
on Tariffs and Trade (GATT).

The main feature of Bretton Woods was that the U.S. dollar replaced gold
as the main standard of convertibility for the world's currencies.
Furthermore, the U.S. dollar became the only currency in the world that
would be backed by gold. (This turned out to be the primary reason why
Bretton Woods eventually failed.)

Over the next 25 or so years, the system ran into a number of problems.
By the early 1970s, U.S. gold reserves were so low that the U.S.
Treasury did not have enough gold to cover all the U.S. dollars that
foreign central banks had in reserve.

Finally, on August 15, 1971, U.S. President Richard Nixon closed the gold
window, essentially refusing to exchange U.S. dollars for gold. This event
marked the end of Bretton Woods.

10
Even though Bretton Woods didn't last, it left an important legacy that still
has a significant effect today. This legacy exists in the form of the three
international agencies created in the 1940s: the International Monetary
Fund, the International Bank for Reconstruction and Development (now
part of the World Bank) and the General Agreement on Tariffs and Trade
(GATT), which led to the World Trade Organization. (To learn more about
Bretton Wood, read What Is The International Monetary
Fund? and Floating And Fixed Exchange Rates.)

Current Exchange Rates

After the Bretton Woods system broke down, the world finally adopted
the use of floating foreign exchange rates during the Jamaica agreement
of 1976. This meant that the use of the gold standard would be
permanently abandoned. However, that doesn't mean that governments
adopted a purely free-floating exchange rate system. Most governments
today use one of the following three exchange rate systems:

Dollarization

Pegged rate

Managed floating rate

Dollarization
Dollarization occurs when a country decides not to issue its own currency
and uses a foreign currency as its national currency. Although
dollarization usually allows a country to be seen as a more stable place for
investment, the downside is that the country's central bank can no longer
print money or control the country's monetary policy. One example of
dollarization is El Salvador's use of the U.S. dollar. (To read more,
see Dollarization Explained.)

Pegged Rates
Pegging is when one country directly fixes its exchange rate to a foreign
currency so that the country will have somewhat more stability than a

11
normal float. More specifically, pegging allows a country's currency to be
exchanged at a fixed rate. The currency will only fluctuate when the
pegged currencies change.

For example, China pegged its yuan to the U.S. dollar at a rate of 8.28
yuan to US$1, between 1997 and July 21, 2005. The downside to pegging
is that a currency's value is at the mercy of the pegged currency's
economic situation. For example, if the U.S. dollar appreciates
substantially against all other currencies, the Chinese yuan will also
appreciate, which may not be what the Chinese central bank wants,
since China relies heavily on its low-cost exports.

Managed Floating Rates

This type of system is created when a currency's exchange rate is allowed
to freely fluctuate subject to supply and demand. However, the
government or central bank may intervene to stabilize extreme
fluctuations in exchange rates. For example, if a country's currency is
depreciating very quickly, the government may raise short-term interest
rates. Raising rates should cause the currency to appreciate slightly; but
understand that this is a very simplified example. Central banks can
typically employ a number of tools to manage currency.

12
Chapter 1.3: Objectives of the study
To understand the foreign exchange market and its working.
To determine how the foreign exchange rate is set.
To determine the factors influencing the foreign exchange rate.
Consequences of foreign exchange rate fluctuations.

Chapter 1.4: Scope of the study

The study covers the following:

Foreign exchange markets.

Factors influencing Foreign Exchange Rates.
Consequences of exchange rate fluctuations.

13
Chapter 1.5: Need for Foreign Exchange
The foreign exchange market is unique because of the following
characteristics:

its huge trading volume representing the largest asset class in the
world leading to high liquidity;
its geographical dispersion;
its continuous operation: 24 hours a day except weekends, i.e.,
trading from 22:00 GMT on Sunday (Sydney) until 22:00 GMT
Friday (New York);
the variety of factors that affect exchange rates;
the low margins of relative profit compared with other markets of
fixed income; and
the use of leverage to enhance profit and loss margins and with
respect to account size.

As such, it has been referred to as the market closest to the ideal of perfect
competition, notwithstanding currency intervention by central banks.

According to the Bank for International Settlements,[3] the preliminary

global results from the 2016 Triennial Central Bank Survey of Foreign
Exchange and OTC Derivatives Markets Activity show that trading in
foreign exchange markets averaged $5.1 trillion per day in April 2016.
This is down from $5.4 trillion in April 2013 but up from $4.0 trillion in
April 2010. Foreign exchange swaps were the most actively traded
instruments in April 2016, at $2.4 trillion per day, followed by spot
trading at $1.7 trillion. According to the Bank for International
Settlements,[4] as of April 2016, average daily turnover in global foreign
exchange markets is estimated at $5.09 trillion, a decline of
approximately 5% from the $5.355 trillion daily volume as of April 2013.
Some firms specializing on the foreign exchange market had put the
average daily turnover in excess of US$4 trillion.[5] The $5.09 trillion
break-down is as follows:

$1.654 trillion in spot transactions

14
 $700 billion in outright forwards

$2.383 trillion in foreign exchange swaps

$96 billion currency swaps

$254 billion in options and other products

15
Chapter 2.1: Review of the Literature
The topic of currency exchange rates and factors influencing their changes
have been reviewed by many scholars in the last decades and still remains
to be one of the hot topics in international economic studies. The first
attempts to analyze exchange rates behavior were done by Rudiger
Dornbusch in 1973, Richard Meese in 1979 and Kenneth Rogoff in 1983.

The Dornbusch (or overshooting) model analyses exchange rate

adjustments considering sticky prices and rational expectations
(Marrewijk, 2007, p. 540-556). In the essay on purchasing power parity
(1987) Dornbusch made clear that it remains an important concept,
though the evidence in recent years is more remarkable for deviations
from, than observance of, such parity (Boykorayev, 2008, p. 22-23).

The combination of exchange rate analysis and the factors that determine
nominal exchange rates was clearly performed by Philip Lane. He did
theoretical and empirical research on long-run exchange rates and built
own model. He analysed long run nominal and real exchange rates of 107
countries in 890 1974-1992, and added to his model such variables like
trade openness, country size, central bank independence and government
debt (Lane, 1999, p. 118-138). Before him all the works had considered a
smaller number of developed countries within less time period. His
econometric results show that the most important factor affecting nominal
exchange rate is inflation and factors driving long-run inflation.
Moreover, openness, output growth and the terms of trade resulted to be
significant, but country size was insignificant. In overall, results show that
the debt effect is most important for high depreciation/inflation countries.
Openness, size, and the stock of nominal government debt - variables that
affect the tendency to inflate - are significant in explaining the rate of
nominal depreciation. However, the results for the terms of trade, another
factor that ought to affect the nominal exchange rate via its influence on
the real exchange rate, are mixed. For the OECD countries, the factors

16
driving inflation appear to dominate the determination of the nominal
exchange rate (Lane, 1999, p. 130).

In 1993 David Romer pointed at the great influence of openness on the

exchange rate trends. In work titled Openness and inflation: Theory and
Evidence he conveys correlation between inflation and openness, but it is
as important for exchange rates as for inflation. Unanticipated monetary
expansion leads to real exchange rate depreciation, and because the harms
of real depreciation are greater in more open economies, the benefits of
unanticipated expansion are decreasing in the degree of openness (Romer,
1993, p. 869-904).

R. MacDonald and L. Ricci studied the long-term determinants of real

exchange rate including economic openness, capital flows and terms of
trade (MacDonald and Ricci, 2003). R.A. Ejaz, A. Abbas and A.R. Saeed
showed a direct relationship between exchange rate and budget deficit
under the managed floating exchange system (Ejaz, Abbas and Saeed,
2002, p. 839-842).

Some researchers do not agree with the statement that the exchange rate is
determined exclusively by fundamentals. J.A. Frankel and K.A. Froot
argue that the high value of the US dollar in 1984 and 1985 can best be
explained as speculative bubble, based on the self-confirming market
expectations driven by the increase in forecasting weight given to the
chartist as a result of their previous forecasting success (Frankel and
Froot, 1990, p. 182).

According to G. Galati and C. Ho news may play an important role in

fluctuations of the euro exchange rate against dollar. The results of the
study show that good news brings appreciation while bad news
depreciates currency (Galati, Ho, 2003, p. 371-398). J.R. Sanchez-Fung
also studied the same relationship and stated that exchange rate is more
responsive in case of depreciation (Sanchez-Fung, 2003, p. 247-250).

In the literature, three principal views on the factors determining

exchange rate levels have been presented, depending on the time horizon

17
and the main conditions for the functioning of economy. Proponents of the
first view indicate that macroeconomic fundamentals play an important
role in explaining the behaviour of exchange rates. Some authors hold that
these fundamentals are important only in the long run but have little to
offer in explaining short-term movements, while others believe that
macroeconomic fundamentals have explanatory power both in the long-
and the short run (McDonald, 1999, p. F673F691).

The second approach is applicable in short time horizons and for countries
without high inflation. According to this view, exchange rate models that
include macroeconomic fundamentals do not perform better than a
random walk in out-of-sample forecasting. Exchange rate volatility is
simply the standard deviation of the error term (Frankel and Rose, 1995;
Rogoff, 1999, p. F655F659).

Adherents to the third view think that neither macroeconomic

fundamentals nor the random walk model adequately account for
exchange rate behaviour at short horizons. Rather, short-run exchange rate
movements are attributed to market microstructure factors, including
inventory management and information aggregation by foreign exchange
dealers. Specifically, the microstructure approach suggests that non-
dealers learn about fundamentals affecting the exchange rate, and this
knowledge is reflected in the orders they place with dealers. Dealers in
turn learn about fundamentals from order flow. The outcome of this two-
stage learning process results in the formation of a price (Lyons, 2001)

18
Chapter 3.1: What is the Foreign Exchange Rate?
The price of a nations currency in terms of another currency. An
exchange rate thus has two components, the domestic currency and a
foreign currency, and can be quoted either directly or indirectly. In a direct
quotation, the price of a unit of foreign currency is expressed in terms of
the domestic currency. In an indirect quotation, the price of a unit of
domestic currency is expressed in terms of the foreign currency. An
exchange rate that does not have the domestic currency as one of the two
currency components is known as a cross currency, or cross rate.

Also known as a currency quotation, the foreign exchange rate

or forex rate.

BREAKING DOWN 'Exchange Rate'

An exchange rate has a base currency and a counter currency. In a direct

quotation, the foreign currency is the base currency and the domestic
currency is the counter currency. In an indirect quotation, the domestic
currency is the base currency and the foreign currency is the counter
currency.

Most exchange rates use the US dollar as the base currency and other
currencies as the counter currency. However, there are a few exceptions to
this rule, such as the euro and Commonwealth currencies like the British
pound, Australian dollar and New Zealand dollar.

Exchange rates for most major currencies are generally expressed to four
places after the decimal, except for currency quotations involving the
Japanese yen, which are quoted to two places after the decimal.

Lets consider some examples of exchange rates to enhance understanding

of these concepts.

US$1 = C$1.1050. Here the base currency is the US dollar and

the counter currency is the Canadian dollar. In Canada, this

19
 exchange rate would comprise a direct quotation of the Canadian
dollar. This is easy to understand intuitively, since prices of goods
and services in Canada are expressed in Canadian dollars; therefore
the price of a US dollar in Canadian dollars is an example of a
direct quotation for a Canadian resident.

C$1 = US$ 0.9050 = 90.50 US cents. Here, since the base currency
is the Canadian dollar and the counter currency is the US dollar,
this would be an indirect quotation of the Canadian dollar in
Canada.

If US$1 = JPY 105, and US$1 = C$1.1050, it follows that

C$1.1050 = JPY 105, or C$1 = JPY 95.02. For an investor based in
Europe, the Canadian dollar to yen exchange rate constitutes a cross
currency rate, since neither currency is the domestic currency.

Exchange rates can be floating or fixed. While floating exchange rates

in which currency rates are determined by market force are the norm for
most major nations, some nations prefer to fix or peg their domestic
currencies to a widely accepted currency like the US dollar.

Exchange rates can also be categorized as the spot rate which is the
current rate or a forward rate, which is the spot rate adjusted for interest
rate differentials.

20
Chapter 3.2: Types of Foreign Exchange Rates
Floating Rates: Floating rates is one of the primary reasons for
fluctuation of currency in foreign exchange market. This is one of the
most important commonly and main type of exchange rate. Under this
market force, all the economies of developed countries allow there
currency to flow freely. When the value of the currency becomes low it
makes the imports more and the exports are cheaper, so the countries
domestic goods and services are demanded more in foreign buyers. The
country can withstand the fluctuation only if the economy is strong. When
the countrys economy is able to meet the demand then it can adjust
between the foreign trade and domestic trade automatically.

Fixed Rates: Fixed exchange rates are used to attract the foreign
investments and to promote foreign trade. This type of rates is used only
by small developed countries. By Fixed exchange rates the country
assures the investors for the stable and constant value of investment in the
country. A monetary policy of the country becomes ineffective. In this
type the exchange rates the imports become expensive. The exchange
value of the currency does not move. This normally reduces the countrys
currency against foreign currencies.

Pegged Rates: This rate is between the floating rate and the fixed rate.
Pegged rates appropriate more for developed country. A country allows its
currency to fluctuation to some extend for adjusted central value. Pegged
allow some adjustments and stability. No artificial rates are found in fixed
and floating exchange rates. Pegged can fix the economic problem by
itself and provide growth opportunity also. When a fixed value is not
maintains by the country it cant follow the fixed exchange rate.

21
Chapter 3.3: Theories of Exchange Rate
The theories of the exchange rate began to flourish in the beginning of
1960s. However, despite their large number and considerable diversity,
most of them consider only some selected issues and there are few works
carried out, conducting a comprehensive analysis of the factors
influencing the exchange rate levels.

The modern explanation of the long-term exchange rate determination is

based upon the theory of purchasing power parity (PPP) between different
currencies, that derives its essential validity from the law of the single
price. According to the purchasing power parity theory, in the long run,
identical products and services in different countries should cost the same.
This is based on the principle that exchange rates will adjust to eliminate
the arbitrage opportunity of buying cheaper goods or services in one
country and selling it at increased prices in another (Boykorayev, 2008,
pp. 8-9). The theory only holds for tradable goods and ignores several real
world factors, such as transportation costs, tariffs and transaction costs.
The other assumption is existence of competitive markets for the goods
and services in all countries.

The relative version of the PPP doctrine avoids some of the weaknesses
characteristic of its absolute version and continues to serve as the
foundation for the theory of evolution of exchange rates over time. It
assumes a causal link between the path of the price of a unit of one
currency in terms of another and the relative dynamics of price levels in
the respective two countries within a lengthy period of time. The
determinants of the long-term behavior of exchange rates through time are
essentially reduced to the same factors which govern the evolution of the
domestic value of money. However, specific factors like changes in the
structure of production (e.g. shift in relative weights of tradables and non-
tradables), differences in dynamics of labour productivity or changes in
the magnitude and composition of aggregate demand are liable to induce
not only temporary but also relatively durable divergences of exchange
rates away from their presumed long-term equilibrium (or PPP) levels
(Lutkowski, 2007, p. 56).

22
Short-term behaviour of exchange rates can be explained by the
uncovered interest parity (UIP) condition (Montiel, 2012, p. 82-87). The
characteristic feature of this approach is regarding currencies basically as
assets. Assuming free cross-border capital mobility and perfect
substitutability of the domestic and currency deposits, the relative demand
for currencies is largely determined by the expected yields, which they
offer. That yield is dependent upon the rates of interest at home and
abroad and upon the expected change in the rate of exchange of the two
currencies (Rubaszek and Serwa, 2009, p. 131-133).

The fundamental importance of the long-term rate of exchange, as

explained by the PPP doctrine with all the attendant qualifications, resides
within this context in anchoring the current exchange rate in expectations
for the future, after accounting for the difference in the foreign and
domestic interest rates. However, long-run general equilibrium implies,
that both the PPP condition and the UIP condition hold simultaneously
(Lutkowski, 2007, p. 56).

23
Chapter 4.1: Classification of Factors affecting
Exchange Rate Levels
The nominal exchange rate is the home-country currency price of a
foreign currency. It measures the relative price of two countries
currencies (in a given moment in the foreign exchange market). The real
exchange rate can be defined as the rate at which two countries goods
trade against each (Reinert, 2012, p. 229-232; Krugman, Obstfeld, 2007,
p. 47). Like any price, exchange rate deviates from the valuation basis -
the purchasing power of currencies - under the influence of demand and
supply of currency. The correlation of such supply and demand depends
on several factors. Exchange rate reflects its relationship with other
economic categories - cost, price, money, interest rate, the balance of
payments (Boykorayev, 2008, p. 9).

There is no consensus in the literature on the factors affecting exchange

rates and their volatility. Usually they are divided into two groups:
economic and non-economic factors. In the first group, we can distinguish
the long-term and short-term factors. Analysing the impact of various
factors on exchange rate, the relative values (in relation to situation
abroad especially in main trading partners countries) should be taken
into account.

24
Economic factors
-Rate of Economic growth
-Inflation rate
-Interest rate in the country and abroad
Short - term
-Current account balance
-Capital account balance
-Currency speculation
-Level of economic development of the country
-Competitiveness of the economy
-Technical and Technological development
Long - term -Size of foreign debt
-Budget deficit
-Relative domestic & foreign prices
- Capital flows
Non Economic Factors
-Political Risk (e.g. Risk of armed conflict)
-Natural disasters
-Policy approaches
-Psychological factors

Recently, global factors have been becoming more and more important. It
also concerns the Polish currency market, that in comparison to the world
market, is characterized by a relatively high share of foreign entities. The
dominance of transactions with non-residents1 indicates that the Polish
foreign exchange market is gaining features of extra-territorial market.
This phenomenon causes the zloty exchange rate fluctuations are strongly
influenced by changes in the financial performance of the global market

25
Chapter 4.2: Factors influencing Foreign Exchange
Rates
Numerous factors determine exchange rates, and all are related to the
trading relationship between two countries. Remember, exchange rates are
relative, and are expressed as a comparison of the currencies of two
countries. The following are some of the principal determinants of the
exchange rate between two countries. Note that these factors are in no
particular order; like many aspects of economics, the relative importance
of these factors is subject to much debate.

1. Differentials in Inflation

As a general rule, a country with a consistently lower inflation rate

exhibits a rising currency value, as its purchasing power increases relative
to other currencies. During the last half of the 20th century, the countries
with low inflation included Japan, Germany and Switzerland, while the
U.S. and Canada achieved low inflation only later. Those countries with
higher inflation typically see depreciation in their currency in relation to
the currencies of their trading partners. This is also usually accompanied
by higher interest rates.

2. Differentials in Interest Rates

Interest rates, inflation and exchange rates are all highly correlated. By
manipulating interest rates, central banks exert influence over both
inflation and exchange rates, and changing interest rates impact inflation
and currency values. Higher interest rates offer lenders in an economy a
higher return relative to other countries. Therefore, higher interest rates
attract foreign capital and cause the exchange rate to rise. The impact of
higher interest rates is mitigated, however, if inflation in the country is
much higher than in others, or if additional factors serve to drive the
currency down. The opposite relationship exists for decreasing interest
rates - that is, lower interest rates tend to decrease exchange rates.

26
3. Current-Account Deficits

The current account is the balance of trade between a country and its
trading partners, reflecting all payments between countries for goods,
services, interest and dividends. A deficit in the current account shows the
country is spending more on foreign trade than it is earning, and that it is
borrowing capital from foreign sources to make up the deficit. In other
words, the country requires more foreign currency than it receives through
sales of exports, and it supplies more of its own currency than foreigners
demand for its products. The excess demand for foreign currency lowers
the country's exchange rate until domestic goods and services are cheap
enough for foreigners, and foreign assets are too expensive to generate
sales for domestic interests.

4. Public Debt

Countries will engage in large-scale deficit financing to pay for public

sector projects and governmental funding. While such activity stimulates
the domestic economy, nations with large public deficits and debts are less
attractive to foreign investors. The reason? A large debt encourages
inflation, and if inflation is high, the debt will be serviced and ultimately
paid off with cheaper real dollars in the future.

In the worst case scenario, a government may print money to pay part of a
large debt, but increasing the money supply inevitably causes inflation.
Moreover, if a government is not able to service its deficit through
domestic means (selling domestic bonds, increasing the money supply),
then it must increase the supply of securities for sale to foreigners, thereby
lowering their prices. Finally, a large debt may prove worrisome to
foreigners if they believe the country risks defaulting on its obligations.
Foreigners will be less willing to own securities denominated in that
currency if the risk of default is great. For this reason, the country's debt
rating (as determined by Moody's or Standard & Poor's, for example) is a
crucial determinant of its exchange rate.

27
5. Terms of Trade

A ratio comparing export prices to import prices, the terms of trade is

related to current accounts and the balance of payments. If the price of a
country's exports rises by a greater rate than that of its imports, its terms
of trade have favorably improved. Increasing terms of trade shows greater
demand for the country's exports. This, in turn, results in rising revenues
from exports, which provides increased demand for the country's currency
(and an increase in the currency's value). If the price of exports rises by a
smaller rate than that of its imports, the currency's value will decrease in
relation to its trading partners.

6. Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with

strong economic performance in which to invest their capital. A country
with such positive attributes will draw investment funds away from other
countries perceived to have more political and economic risk. Political
turmoil, for example, can cause a loss of confidence in a currency and a
movement of capital to the currencies of more stable countries.

7. Capital Account Balance

For any country current account deficit indicates higher values of imports
of services and goods in comparison to the values of exports. Countries
having surplus in their financial account are benefited than countries with
deficit. They can attract more capital from other countries and can see
appreciation in the currency value relative to the countries with capital
account deficit.

8. Role of Speculators

Speculator is a person who takes more risk in investment, and can do a

major change in the future price of the asset. If they believe the Indian
Rupee will increase in near future, they start demanding Rupee now to
earn profit in future. This kind of demand causes Indian Rupee value to

28
rise. Such movement doesnt reflect any economical fundamentals; they
are only due to positive sentiments of the financial markets. Like, if
financial investors see news about a rate of interest decreasing, exchange
value of Rupee will go down most probably.

9. Cost of Manufacture

If the country can produce goods at more economical rate, they can sell
goods at attractive price. In anticipation to low rate export increases and
in affect of this value of currency also increases. China is the best
example of competitive market for economical goods in the world. It
gives rise to the currency of any country in longer term.

10. Debt of the Country

Countries spending more on public sector projects and fund for social
upliftment of the society has more debt on the country. Such spending
stimulates the domestic economy. Countries with higher public debt are
not attractive to foreign investors. Because higher debt of the country
leads to higher inflation ultimately increases debt to control inflation.
Some standard organizations like Standard & Poors, Moodys gives debt
rating of the country, and it is very important determinant of its exchange
rate.

11. Gross Domestic Product

The gross domestic product of a country is a measure of all of the

finished goods and services that a country generated during a given
period. GDP gives best measure of health of countrys economy. It is the
number calculated by consolidation of total expenses of government,
money spent by business, private consumption and exports of the country.
Increment in GDP indicates economic growth. Foreign investors get
attracted towards the countries with economically strong countries with
good GDP. It leads to better valuation of the currency of the country
because more and more money comes to the country.

29
12. Employment Data

Employment data indicates level of prosperity of economy. Generally

countries release their data of employment after certain interval. As the
rate of employment is higher people in the country gets enough chance for
work of their choice and expertise. In most cases the value of currency
increases as the number of unemployed people decreases. But sometimes
high employment increases purchase power parity of the people and can
lead to higher inflation in the country, so it can adversely affect valuation
of the currency.

13. Relative Strength of other Currencies

Currency valuations are also equally affected by global parameters.

Countrys economical strength is compared with other countries strength
and if other countries are strong money moves to those countries. It
ultimately reduces valuation of the country with comparatively poor
health of the economy.

14. Macroeconomic and Geopolitical events

In the case of events like elections, wars, monetary policy changes,

financial crisis, currency of the country is highly affected. Such
macroeconomic and geopolitical events also affect other parameters.
These events have the ability to change or reshape of the country
including fundamentals of the country. For example, wars can put a huge
economic strain on a country and greatly increase the volatility in a
region, which could impact the value of its currency. It is important to
keep up to date on these macroeconomic and geopolitical events.

30
15. Political and Psychological factors

Political and psychological factors are believed to have an influence on

exchange rates. Many currencies have a tradition of behaving in a
particular way for e.g. Swiss Franc as a refuge currency. The US Dollar is
also considered a safer haven currency whenever there is a political crisis
anywhere in the world.

16. Capital Movement

The phenomenon of capital movement affecting the exchange rate has a

very recent origin. Huge surplus of petroleum exporting countries due to
sudden spurt in the oil prices could not be utilized by these countries for
home consumption entirely and needed to be invested elsewhere
productively. Movement of these petro dollars, started affecting the
exchange rates of various currencies. Capital tended to move from lower
yielding to higher yielding currencies and as a result the exchange rates
moved. 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 todays 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.

17. Fiscal policy

The fiscal policy followed by the government has an impact on the

economy of the country which in turn affects the exchange rates. If the
government follows an expansionary policy by having low interest rates,
it will fuel the engine of economic growth and will lead to better trade
performance. However, a word of caution is necessary here. If the
government is following an expansionary policy by resorting to high
budget deficit and monetizing the deficit, this will lead to high inflation in
the economy. This will prove to be counter productive as far as growth in
exports is concerned.

31
18. Monetary policy

The central banks in various countries have control over the monetary
policy to be pursued although it is generally in consonance with the fiscal
policies of the government, The monetary policy is a very effective tool
for controlling money supply, and is used particularly for keeping a tab on
the inflationary pressures in the economy.

The main objective of monetary policy of any economy is to maintain the

money supply in the economy at the level which will ensure price
stability, full employment and growth in the economy. Monetary policy
pursued by the central bank also gives a hint about the future interest
rates. If the money supply in the economy is more it will lead to inflation
and the central bank will raise the interest rates , sell government
securities through open market operations, raise cash reserve requirements
thus giving a signal for right money supply policy. On the other hand, to
spur the growth in the economy the central bank may lower the interest
rate, buy government securities in the market, and lower the cash reserve
requirements thus heralding an era of easy money policy. This will be a
sign for lower interest rates in the future. It will be clear from the above
discussion that monetary policy influences interest rates, inflation,
employment, etc and consequently affects the exchange rates.

19. 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

20. Balance of Payments

Balance of payments position of a country is a definite indicator of the

demand and supply of foreign exchange. If a country is having a
favourable balance of payments position it implies that there is more
supply of foreign exchange and therefore foreign currencies will tend to
be cheaper vis--vis domestic currency. However, if balance of payments
position is unfavourable, it indicates that there is more demand for foreign

32
exchange and this will result in the price of foreign currency vis--vis
domestic currency firming up.

21. Exchange Control

Exchange control is generally aimed at disallowing free movement of

capital flows and it therefore affects the exchange rates. Sometimes
countries exercise control through exchange rate mechanism by keeping
the price of their currency at an artificial level. If a country wants to give
boost to exports, it will keep the value of its currency vis--vis the foreign
currency low. This will help the exporters in realizing more units of the
local currency for the same units of foreign currency received by them as
export earnings. However, reverse would be the case if the government
decides to follow a liberal import policy.

22. Technical Factors

Technical factors, particularly in the short run, can influence the exchange
rates. If, for example, regulations by central bank make it necessary to
make limit the size of open position and if banks are having a big short
position, they may, in order to cover such a position, buy foreign
exchange. This will result in short term higher demand which is not
genuine. Similarly, reserve requirement of the central bank may also
create a technical position thus influencing the exchange rates.

33
Chapter 4.3: Consequences of Exchange Rate
Fluctuations
A high exchange rate will mean that prices of exports are higher and
imports are lower. This will reduce demand for exports and reduce AD. A
reduction in AD will create unemployment and reduce economic growth.
This would therefore deteriorate the current account.

Similar effects are added by an increased demand for imports, however

this is all dependent on the price elasticities of exports and imports.
Should they be price inelastic, then there is likely to be little change.
Lower import prices can be beneficial to customers however. This is
because households can buy more goods and services which is likely to
increase their living standards.

Fluctuating exchange rates however are riskier because they create

uncertainty. Producers will be reluctant to buy international stock for fear
that its value will depreciate in the following months. The profit of selling
the goods may be less than what it was initially or perhaps more.
Uncertainty therefore acts as a disincentive to trade.

There are ways to avoid this risk however. One way is to use future
markets. This is where firms can guarantee an exchange rate by buying
currencies at a fixed rate some point in the future.

World prices despite exchange rate fluctuation are stable. This is because
exporters price their products for their export markets and absorb
exchange rate changes in their profit margins. This means that exchange
rate fluctuations, while important, do not have as strong an impact on
international trade that some may claim.

Nevertheless, the argument for exchange rate stability still exists with
some arguing the case for a single currency as is the case with the EU.
They believed that since trade was high between their countries, a fixed
exchange rate would be beneficial and encourage trade and investment.

34
Chapter 5: Conclusion
Exchange rates are basically the prices of one currency in terms of other
currencies driven by the normal forces of supply and demand. The
empirical studies relating to the link between exchange rate variability and
its factors are not conclusive.

The conducted analysis reveals that the financial account balance and
inflation rate are the most important factors determining the level of
EUR/PLN exchange rate. While a rise in Polands financial account
surplus contributes to appreciation of the countrys currency, an increase
in inflation rate has a negative effect and reduces the value of Polish
currency.

The market interest rate is the third most important factor determining the
zloty exchange rate level. The relative rise in interest rates contributes to
appreciation of the Polish currency, because it encourages foreign
investors to invest in Poland. The fourth important variable which bring
more variation in the zloty exchange rate is the government deficit, while
the economic growth and the current account are less significant.

Based on these evidence it is clear that in Poland fiscal and monetary

policies play an important role in affecting the zloty exchange rate
changes. It is recommended to harmonize these both policies and to make
an effective link between them and other economic policies (like
investment or trade policy). Effective and smooth running of fiscal and
monetary policies are required to reduce inflation and boost up economic
growth.

35
Chapter 6: Bibliography
Sources of data:

Wikipedia.com
Investopedia.com
Scribd.com
Economist.com

36