What is Exchange Rate Determination?
Exchange rate determination refers to the process by which the value of one currency is established in terms of another currency. In other words, it involves understanding the factors that influence the relative value of different currencies in the foreign exchange market. Exchange rates are crucial in international trade and finance, as they affect the cost of goods and services, investment decisions, and overall economic performance.
Table of Content
On 22 July 1944, at Bretton Woods, US, 44 countries mutually agreed and approved that a broad international monetary system was required for the promotion of international trade. With respect to this, the Bretton Woods Agreement established an international system of fixed exchange rates between currencies. The basis ‘tool’ was determined as gold, with the respective quotation.
After the introduction of the fixed exchange rate system, all other currencies in the exchange system were pegged to the USD at a fixed exchange rate. However, later in the 1960s, the gold ratio was becoming difficult to sustain. The demand for gold increased constantly while the US gold reserves were depleting. Therefore, on 15 August 1971, the then US President, Richard Nixon, renounced the international obligation of the US to exchange dollar at gold rates. By 1974, gold had jumped from USD 35 per ounce to USD 195 per ounce.
Since the failure of the Bretton Woods Agreement in February 1973, global currencies have adopted a floating rate with respect to the US dollar. Therefore, foreign exchange rate determination transformed from a fixed exchange rate against gold to a flexible or floating ex- change rate. The system through which currency exchange rates are determined by supply and demand is referred to as ‘clean float’. On the other hand, the system where governments and central banks interact in the forex market is referred to as ‘dirty float’.
Several theories have been postulated with respect to the exchange rate determination. Some of the more accepted ones include the supply and demand theory, Purchasing Power Parity (PPP), the balance of payment approach, the monetary approach and the portfolio balance approach as follows:
- Supply and Demand Theory: Under this mechanism, the demand and supply forces of the given currency determine the foreign exchange rate.
- Purchasing Power Parity (PPP): The theory of PPP states that the exchange rate between currencies of two countries should be equal to the ratio of the price levels prevailing in these two countries.
- Balance of Payment Approach: It specifies that the exchange rate of a country depends on the position of balance of payments of that country. The external value of the currency of a country is appreciated if that country has favourable balance of payments. On the other hand, the external value of the currency of a country is depreciated if it has unfavourable balance of payments.
- Monetary Approach: The monetary policy affects the availability and cost of money in the economy. The central bank achieves this by controlling the interest rates by affecting the credit availability that ultimately impacts the prices and exchange rate.
- Portfolio Balance Approach: Under this, a portfolio is built by comprising domestic and foreign assets. These assets may include bonds or money characterised by an expected return and arbitrage opportunity that helps in determining exchange rates.
Although most of these theories explain the determination of exchange rates of different currencies, there are still various factors that cause changes in currency rates. As a result, there is no particular theory that provides answers to the question of what determines exchange rates.
Factors Affect the Determination of Exchange Rate
The following factors affect the determination of the exchange rate:
Capital movements
Foreign capital movements from one economy to the other are made for short periods to avail a high rate of interest. It is also made for long periods for the purpose of long-term investment in the foreign country. An export/import of capital from one country to the other results is a change in the exchange rate.
For example, if a considerable amount of capital is moved from the US to India, the demand for INR (or the supply of USD) in the exchange market would increase in such a way that the exchange value of INR with respect to USD would increase. Thus, INR would appreciate in value against USD. The opposite would be true in case there is a movement of capital from India to the US.
Trade movement
The pattern of imports or exports results in a change in the currency exchange rate. In case, imports exceed exports, the demand for foreign currency would rise. Therefore, the rate of exchange would move against the economy. On the other hand, if the exports are more than imports, the demand for domestic currency would increase and the rate of exchange would move in favour of the said economy.
Banking operations
Banks constitute major dealers of the foreign exchange market. They sell demand drafts, transfer funds, issue credit, accept foreign bills of exchange, carry out arbitrage operations, etc. These operations affect the demand for and supply of foreign exchange and thus exchange rates. Bank rates also have a significant impact on the rate of exchange.
An increase in bank rate attracts foreign funds. This results in an increase in the demand for domestic currency and the rate of exchange goes up. The opposite is true in case the bank rate decreases.
Inflation and deflation
Inflation and deflation affect the internal value of money. This reflects a similar change in the external value of money. Inflation refers to a rise in the domestic price level, fall in the purchasing power of money, and thus, a decrease in the exchange rate. On the other hand, deflation results in a fall in domestic prices and increase in the exchange rate.
Political conditions
Political conditions within a country have a significant and direct impact on the rate of its currency. This is because a favourable political condition attracts foreign capital. This in turn increases the foreign exchange rate. Political instability, on the contrary, results in a panic flight of capital from the domestic country.
This results in the depreciation of its value and consequently, a fall in the exchange rate of the domestic currency. In fact, the political conditions of a country are also a strong factor both in exchange rate speculation and movement of foreign capital.
Stock exchange operations
These operations consist of the grant of loans, payment of interest on foreign loans, return of foreign capital, buying and selling foreign securities, etc. Stock exchange transactions affect the demand for foreign funds.
This eventually affects the rate of exchange for foreign currency. If a loan is granted by the domestic country to a foreign country, the demand for foreign currency rises. In turn, the exchange rate tends to move against the domestic country. However, when foreign investors repay their loan, the demand for domestic currency exceeds its supply. This results in increase in the exchange rate.
Speculative transactions
These include transactions arising out of the expectation of cyclical changes in the rate of exchange. In times of political uncertainty, there is increased speculation in the foreign currency. Investors promptly buy certain currencies, while sell off certain currencies. These speculations bring about wide fluctuations in the exchange rates.
