Determinants of currency exchange rates
Exchange rates are influenced by a wide range of factors in the economy and the importance of each of these factors may vary from one country to another and generally over time. Theexchange rate of a countrys level of economic performance. Exchange rates determine thetrade activities of a country which is a critical aspect of the free market economy system.Numerous factors do affect the exchange rates in a country but there are only about four majorfactors.
Inflation rates differentials
Generally countries with lower inflation rate differentials consistently usually exhibit a rise thevalue of the currency, as it value appreciates relative to other world currencies looking at thestatistics, countries with low inflation rate over the last decade or so, has exhibitedappreciation in their currencies and such economic dominance in the free market system.Inflation rates have an effect of influencing the demand and supply of foreign currencies is highwhile demand for local, currencies is low. As such pressure in the market will causedepreciation in the local currency relative to the foreign currency.
Balance of payment deficits
When talking about the balance of payments in this case the area of general interest is thecurrent account. Balance of payment. This usually represents the balance of cash inflows andoutflows or simply transactions from trade between one country and others. A deficit in thebalance of payments account usually represents an excess of cash outflows relative to cashinflows or simply transactions from trade between one country and others. A deficit in thebalance of payments account usually represents an excess of cash outflows relative to cash inflows in a country i.e. payments exceed receipts and as a consequence it is required to borrowsand to get grants from abroad in order to offset the deficit with capital account surpluses. Insimple terms the country is acquiring less foreign currency from demand for foreign currencyand thus lowering the value of the local currency. Therefore its evidenced that current accountdeficits do affect the exchange rate.
Terms of trade
Under the law of one price principle, one should be able to purchase commodities in differentcountries at the same price given that there is a floating exchange rate regime. Therefore anunfavourable increase in the prices of a country exports relative to the imports prices anddemand, then, its currency value will decrease in relation to that of its trading partners.