Some Basic Relationship

Suppose that individuals were not worried about risk and that there were no barrier or costs to international trade. In this situation spot exchange rates, forward exchange, interest rates and inflation rates would stand in following simple relationship to one another.

Changes in the exchange rates and inflation rates:

Let us understand now the relationship between exchange rate and inflation. Suppose you notice that silver can be bought in New York for $4.80 per unit and sold in Zurich for sfr7. then you exchange your sfr for 7, @ $/1.3125 = $ 5.33 You make gross profit of $.53 per unit: Such situations does not exist-not long as others notice the disparity between the price of silver in Zurich and price in New York, price will be forced down in Zurich and up in New York until the profits opportunity disappear. Arbitrage ensures that dollar price of silver is about the same in the two countries. Of course silver is a standard and easily transportable commodity but to some degree you might expect that same forces would be acting to equalize the domestic and foreign 3 prices of other goods.

Those goods that can be bought more cheaply abroad would be imported and that will force down the price of domestic product. Similarly those goods that can be bought more cheaply in USA will be exported and that will force down the price of foreign product. This is often called the law of one price or in more general sense purchasing power parity theory. Law of one price implies that any differences in the rates of inflation will be offset by I change in exchange rate.

FACTORS AFFECTING EXCHANGE RATES.

In floating rate the exchange rates fluctuate because of change in demand and supply of currency.
Principal factors affecting exchange rate are 1. Short term factors. a. Commercial factors. b. Financial factors.

2. Long term factors a. Currency and economic conditions. b. Political and industrial conditions.

Case of Short Term Time Horizon

1) Country's current account balance is better indicator of exchange rate trends. Surplus i.e. foreign exchange net inflows from export earnings pushes country's currency value higher as has happened in recent times with regard to rupee vs. dollar. A nations international competitiveness and with it the trend of its current account depends on different factors. Inflation will diminish export after a certain future period and increase imports. 2) High economic growth of a country strengthens the home currency. 3) Foreign currency inflows from trade and services (banking, shipping, tourism and so on) strengthens dometic currency. 6

4) Loan and interest rate receipts and payments in foreign

currency by private and public sector influences the demand and supply of foreign currency and resultantly its value. 5) Salaries and profits of foreign companies and their remittances also influence the demand and supply of foreign currency and its value. 6)Capital movements also dominate exchange rate developments over weeks/months. Technical factors: For short period technical factors can sometimes have influence on exchange rates. Regulations by Central Bank about size of open positions, make it necessary to reduce or cover short positions at any given moment and it create a technical but genuine demand for currency.
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Long term factors:

1. Economic factors are of decisive importance. These can be ranging from GDP growth rate, industry growth, agricultural growth, inflation, interest rates and so on.

2. Non economic factors: Political or psychological factors can also have a bearing on exchange rate behaviour, inflation, interest rates and so on. 3. Market participants not only act on the basis known facts and figures but they also base them selves on expectations. This factor adds to volatility of foreign exchange market.
4. Speculative activities by private sector. 5. Industrial conditions: Current position and future outlook in the industrial field are also important influences in the exchange market.
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Existence of industry peace, stable level of wages, prices, high level of efficiency of production contribute to strengthening effect on the exchange value of currency in the long period. Conversely industrial unrest, unduly high cost of production, inefficient production, have an adverse effect on the exchange value of currency.