Factors Influencing the Foreign Exchange Rate

The exchange rate between countries changes due to change in demand or supply in the foreign exchange market. The factors which cause changes in demand and supply are discussed as under.

1. Changes in Prices: It is changes in the relative price levels that cause changes in the exchange rate. Suppose price level in Britain rises relative to the US price level. This will lead to the rises in the price of British goods in terms of pounds. British goods will become dearer in the US. This will lead to reduction in British exports to the US. So the supply of dollars to Britain will diminish. On the other hand, the American goods become cheaper in Britain and their imports into Britain increase. So the demand for dollars will increase. Thus the supply curve for dollars will shift to the left so that the exchange rate is established at a higher level from the point of view of the US. It implies appreciation of the value of the dollars and depreciation of the value of the pound.

2. Changes in Exports and Imports: The demand and supply of foreign exchange is also influenced by changes in exports and imports. If exports of the country are more than imports, the demand for the country is more than imports, the demand for its currency increases so that the rate of exchange moves in its favour. Conversely, if imports are more than export the demand for the foreign currency increase and the rate of exchange will move against the country.

3. Capital Movements: Short term or long term capital movements also influence the exchange rate capital flows tend to appreciate the value of the currency of the capital importing country and depreciate the value of the currency of the capital exporting country. The exchange rate will move in favour of the capital importing country and against the capital exporting country. The demand for the currency of the capital importing country will rise and its demand curve will shift upward to the right and exchange rate will be determined at a higher level, given the supply curve of foreign exchange.

4. Influence of Banks: Banks also affect the exchange rate through their operation. They include the purchase and sale of bank drafts, letters of credit, arbitrage, dealing in the bills of exchange etc. These banking operations influence the demand for and supply of foreign exchange. If the commercial banks issue a large number of drafts and letters of credit on foreign banks, the demand for foreign currency rises. The bank rate also influences exchange rate. If the bank rate rises relative to other countries, more funds will flow into the country from abroad to earn high interest rate. It will tend to raise the demand for the domestic currency and exchange rate will move in favour of the country. Converse will be the case when the bank rate falls.

5. Influence of Speculation: The growth of speculative activities also influences the exchange rate. Uncertainty in the international money market encourages speculation in foreign exchange. If the speculators expect a fall in the value of currency in near future, they will sell that currency and start buying the other currency, they expect to appreciate in value. Consequently, the supply of former currency will increase and its exchange rate will fall. While the demand for the other currency will rise and its exchange rate will go up.

6. Stock Exchange Influences: Stock exchange operations in foreign currencies, debentures, stocks and shares etc exert significant influence on the exchange rate. If the stock exchanges help in the sale of securities debentures shares etc to foreigners, the demand for the domestic currency will rise in the part of the foreigners and the exchange rate also tends to rise. The opposite will be the case if the foreigners purchase securities, debentures shares etc through the domestic stock exchanges.

7. Structural Influences: Structural changes are another important factor which influences the exchange rate of a country. Structural changes are those changes which bring changes in the consumer demand for commodities. They include technological changes, the innovations etc which also affect the cost structure along with the demand for products. Such structural changes tend to increase the foreign demand for domestic production. It implies increase in exports, greater demand for domestic currency, appreciation of its value and rise in the exchange rate.

8. Political Conditions: Political conditions in the country have a significant influence on the exchange rate. If there is political stability and the government is strong and efficient, foreigners will have tendency to invest their funds into the country. With the inflow of capital the demand for domestic currency will rise and the exchange rate will move in favour of the country. On the contrary, if the government is weak, inefficient and dishonest and there is no safety to life and property, capital will flow out of the country and the exchange rate will move against the country.