12/7/11 6 Factors That Influence Exchange Rates

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6 Faco Tha Inflence
Echange Rae
Email Print Posted: Jul 23, 2010 Reprints
FILED UNDER BONDS BONDS ECONOMICS INVESTING BASICS
Jaon Van Begen
Contact Author Bio
Aide fom faco ch a inee ae and
inflaion, he echange ae i one of he mo
impoan deeminan of a con' elaie
leel of economic healh. Echange ae pla
a ial ole in a con' leel of ade, hich
i ciical o mo ee fee make econom
in he old. Fo hi eaon, echange ae
ae among he mo ached, analed and
goenmenall maniplaed economic
meae. B echange ae mae on a
malle cale a ell: he impac he eal
en of an ineo' pofolio. Hee e look
a ome of he majo foce behind echange
ae moemen.
Oerie
Befoe e look a hee foce, e hold kech o ho echange ae moemen affec a
naion' ading elaionhip ih ohe naion. A highe cenc make a con' epo
moe epenie and impo cheape in foeign make; a loe cenc make a con'
epo cheape and i impo moe epenie in foeign make. A highe echange ae can
be epeced o loe he con' balance of ade, hile a loe echange ae old inceae
i.
Determinants of Echange Rates
Nmeo faco deemine echange ae, and all ae elaed o he ading elaionhip
beeen o conie. Remembe, echange ae ae elaie, and ae epeed a a
compaion of he cencie of o conie. The folloing ae ome of he pincipal
deeminan of he echange ae beeen o conie. Noe ha hee faco ae in no
paicla ode; like man apec of economic, he elaie impoance of hee faco i
bjec o mch debae.
1. Differentials in Inflation
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Balance o ading pofolio--hedge o cenc
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12/7/11 6 Factors That Influence Exchange Rates
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As u generuI ruIe, u counLry wILI u consIsLenLIy Iower InIIuLIon ruLe exIIbILs u rIsIng currency
vuIue, us ILs purcIusIng power Increuses reIuLIve Lo oLIer currencIes. DurIng LIe IusL IuII oI
LIe LwenLIeLI cenLury, LIe counLrIes wILI Iow InIIuLIon IncIuded Jupun, Germuny und
SwILzerIund, wIIIe LIe U.S. und Cunudu ucIIeved Iow InIIuLIon onIy IuLer. TIose counLrIes wILI
IIgIer InIIuLIon LypIcuIIy see deprecIuLIon In LIeIr currency In reIuLIon Lo LIe currencIes oI
LIeIr LrudIng purLners. TIIs Is uIso usuuIIy uccompunIed by IIgIer InLeresL ruLes. (To Ieurn more,
see Cost-Push Inflation Versus Demand-Pull Inflation.)
2. Diffeenial in Inee Rae
nLeresL ruLes, InIIuLIon und excIunge ruLes ure uII IIgIIy correIuLed. By munIpuIuLIng InLeresL
ruLes, cenLruI bunks exerL InIIuence over boLI InIIuLIon und excIunge ruLes, und cIungIng
InLeresL ruLes ImpucL InIIuLIon und currency vuIues. HIgIer InLeresL ruLes oIIer Ienders In un
economy u IIgIer reLurn reIuLIve Lo oLIer counLrIes. TIereIore, IIgIer InLeresL ruLes uLLrucL
IoreIgn cupILuI und cuuse LIe excIunge ruLe Lo rIse. TIe ImpucL oI IIgIer InLeresL ruLes Is
mILIguLed, Iowever, II InIIuLIon In LIe counLry Is mucI IIgIer LIun In oLIers, or II uddILIonuI
IucLors serve Lo drIve LIe currency down. TIe opposILe reIuLIonsIIp exIsLs Ior decreusIng InLeresL
ruLes - LIuL Is, Iower InLeresL ruLes Lend Lo decreuse excIunge ruLes. (or IurLIer reudIng, see
What Is Fiscal Polic?)
3. Cen-Accon Defici
TIe currenL uccounL Is LIe buIunce oI Lrude beLween u counLry und ILs LrudIng purLners, reIIecLIng
uII puymenLs beLween counLrIes Ior goods, servIces, InLeresL und dIvIdends. A deIIcIL In LIe
currenL uccounL sIows LIe counLry Is spendIng more on IoreIgn Lrude LIun IL Is eurnIng, und LIuL
IL Is borrowIng cupILuI Irom IoreIgn sources Lo muke up LIe deIIcIL. n oLIer words, LIe counLry
requIres more IoreIgn currency LIun IL receIves LIrougI suIes oI exporLs, und IL suppIIes more oI
ILs own currency LIun IoreIgners demund Ior ILs producLs. TIe excess demund Ior IoreIgn
currency Iowers LIe counLry's excIunge ruLe unLII domesLIc goods und servIces ure cIeup enougI
Ior IoreIgners, und IoreIgn usseLs ure Loo expensIve Lo generuLe suIes Ior domesLIc InLeresLs. (or
more, see Understanding The Current Account In The Balance Of Paments.)
4. Pblic Deb
CounLrIes wIII enguge In Iurge-scuIe deIIcIL IInuncIng Lo puy Ior pubIIc secLor projecLs und
governmenLuI IundIng. WIIIe sucI ucLIvILy sLImuIuLes LIe domesLIc economy, nuLIons wILI Iurge
pubIIc deIIcILs und debLs ure Iess uLLrucLIve Lo IoreIgn InvesLors. TIe reuson? A Iurge debL
encouruges InIIuLIon, und II InIIuLIon Is IIgI, LIe debL wIII be servIced und uILImuLeIy puId oII
wILI cIeuper reuI doIIurs In LIe IuLure.
n LIe worsL cuse scenurIo, u governmenL muy prInL money Lo puy purL oI u Iurge debL, buL
IncreusIng LIe money suppIy InevILubIy cuuses InIIuLIon. Moreover, II u governmenL Is noL ubIe Lo
servIce ILs deIIcIL LIrougI domesLIc meuns (seIIIng domesLIc bonds, IncreusIng LIe money
suppIy), LIen IL musL Increuse LIe suppIy oI securILIes Ior suIe Lo IoreIgners, LIereby IowerIng
LIeIr prIces. InuIIy, u Iurge debL muy prove worrIsome Lo IoreIgners II LIey beIIeve LIe counLry
rIsks deIuuILIng on ILs obIIguLIons. oreIgners wIII be Iess wIIIIng Lo own securILIes denomInuLed
In LIuL currency II LIe rIsk oI deIuuIL Is greuL. or LIIs reuson, LIe counLry's debL ruLIng (us
deLermIned by Moody's or SLundurd & Poor's, Ior exumpIe) Is u crucIuI deLermInunL oI ILs
excIunge ruLe.
5. Tem of Tade
A ruLIo compurIng exporL prIces Lo ImporL prIces, LIe Lerms oI Lrude Is reIuLed Lo currenL uccounLs
und LIe buIunce oI puymenLs. I LIe prIce oI u counLry's exporLs rIses by u greuLer ruLe LIun LIuL
oI ILs ImporLs, ILs Lerms oI Lrude Iuve IuvorubIy Improved. ncreusIng Lerms oI Lrude sIows
greuLer demund Ior LIe counLry's exporLs. TIIs, In Lurn, resuILs In rIsIng revenues Irom exporLs,
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FILED UNDER BONDS BONDS ECONOMICS INVESTING BASICS
hich poide inceaed demand fo he con' cenc (and an inceae in he cenc'
ale). If he pice of epo ie b a malle ae han ha of i impo, he cenc' ale
ill deceae in elaion o i ading pane.
6. Political Stabilit and Economic Performance
Foeign ineo ineiabl eek o able conie ih ong economic pefomance in
hich o ine hei capial. A con ih ch poiie aibe ill da inemen fnd
aa fom ohe conie peceied o hae moe poliical and economic ik. Poliical moil,
fo eample, can cae a lo of confidence in a cenc and a moemen of capial o he
cencie of moe able conie.
Conclusion
The echange ae of he cenc in hich a pofolio hold he blk of i inemen
deemine ha pofolio' eal en. A declining echange ae obiol deceae he
pchaing poe of income and capial gain deied fom an en. Moeoe, he
echange ae inflence ohe income faco ch a inee ae, inflaion and een capial
gain fom domeic eciie. While echange ae ae deemined b nmeo comple
faco ha ofen leae een he mo epeienced economi flmmoed, ineo hold ill
hae ome ndeanding of ho cenc ale and echange ae pla an impoan ole in
he ae of en on hei inemen.
Fo fhe eading, ee Floating And Fied Echange Rates.
b Jason Van Bergen
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