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Factors that affect exchange rates

Like any price, the exchange rate deviates from the cost basis - the purchasing power of currencies under the influence of supply and demand of currency. The ratio of the supply and demand depends on several factors. It reflects connections with other economic categories - cost, price, money, interest, balance of payments, etc. There is a complex of interweaving and nomination of decisive factors. Among them are the following.

1.The rate of inflation.


The ratio of currency in their purchasing power (purchasing power parity) serves as a kind of axis of the exchange rate reflecting the law of value. That's why the rate of inflation has an impact on the exchange rate. All other things being equal, the inflation rate in the country has inversely proportional impact on the value of national currency, i.e. an increase in inflation in the country leads to a reduction in the national currency, and vice versa. Inflationary depreciation of money in the country reduces the purchasing power and a tendency to a drop in their currency's exchange rate against currencies of countries where the rate of inflation is lower. Alignment of the exchange rate and adjustment to purchasing power parity are occurred within two years. This is because the daily quotation of exchange rates is not corrected on the basis of their purchasing power, and there are other factors of forming of exchange rates.

2.The balance of payments.


Balance of payments directly affects the value of the exchange rate. Thus, the active balance of payments improves the national currency as the demand from foreign debtors increases. The passive balance of

payments leads to a tendency to a decrease in the national currency's exchange rate as domestic debtors try to sell everything using a foreign currency to repay their external obligations. The size of the impact of balance of payments on the exchange rate is determined by the degree of openness of the economy. Thus, the higher the share of exports in gross national product (the higher the openness of the economy), the higher the elasticity of the exchange rate. In addition, the exchange rate affects economic policy of the state in components of the balance of payments: current account and capital account. For example, the effect of changes in tariffs, import restrictions, trade quotas, export subsidies has an impact on the trade balance. When the positive balance of trade is on the advance there is an increase in the demand for the currency of the country that raises its rate, and in case of negative balance the reverse process occurs. Movement of short-term and long-term capital depends on the level of domestic interest rates, restrictions or encourage of import and export of capital. Changes in the balance of capital have an impact on the currency, which is similar to the trade balance by its mark (plus or minus). However, there is a negative influence of excessive short-term capital inflows into the country on the rate of its currency because it can increase the excess money supply, which, in turn, may lead to higher prices and the depreciation of the currency.

3.The difference in interest rates in different countries.

The influence of this factor on the exchange rate is explained by two main factors. First, changes in interest rates in a country affect, all else being equal, international capital flows, especially short-term ones. In principle, an increase in the interest rate stimulates the inflow of foreign capital and its cutting promotes the reduction of outflow of capital, including national. That is why in a country with higher interest rates capital comes into, the demand for its currency increases, and it becomes expensive. The movement of capital, especially speculative "hot" money, increases instability of the balance of payments. Secondly, interest rates affect the operation of foreign exchange markets and money markets. When executing transactions, banks take into account the difference in interest rates on national and global capital markets with a view of deriving of profit. They prefer to get cheaper loans in foreign money markets, where rates are lower, and place foreign currency on the domestic credit market, if its interest rates are higher. On the other hand, the nominal increase in interest rates in the country reduces the demand for domestic currency as receipt of credits becomes expensive for business. In case of taking out a loan, an entrepreneur increases the cost of their product that, in turn, leads to higher prices for goods inside the country. This relatively devalues the national currency against a foreign one.

4.Activities of foreign exchange markets and speculative currency transactions.


If the rate of a currency tends to decline firms and banks sell it for a more stable currency and it worsens the position of weakened currency. Currency markets react quickly to changes in the economy and politics, fluctuations in exchange ratios. In doing so, they increase opportunities of currency speculations and spontaneous movement of "hot" money.

5.The degree of confidence in the national and world currency markets.


It depends on the economy and political situation in the country as well as the factors indicated above which affect the exchange rate. Dealers take into account not only the rate of economic growth, inflation, the purchasing power of currencies, the balance of demand and supply of currency, but the prospects of their dynamics. Sometimes, even the expectation of the publication of official data on the trade balance and the balance of payments or election results affects the ratio of supply and demand and currency rate. Sometimes, in the currency market there is a change of priorities in favor of political news, rumors of resignations of ministers, etc.

6.The monetary policy.


The ratio of market and state regulation of the exchange rate affects its dynamics. The formation of the exchange rate on foreign exchange markets through the mechanism of demand and supply of currency is usually accompanied by sharp fluctuations in exchange relations. Real exchange rate forms in the market which is an indicator of the economy, money, finance, credit and confidence in a certain currency. State regulation of the exchange rate is aimed at its raising or lowering on the basis of the purposes of monetary and economic policy.

7.National income is not an independent component that can change itself.


However, in general, the factors which lead to changes in the national income have a great impact on the exchange rate. Thus, an increase in the supply of products enhances the exchange rate, while increases in domestic demand reduce its rate. In the long run, a higher national income means higher value of the currency of the country.

8.Market factors.These factors can significantly change the value of currency at short intervals.
Thus, the overall expectations for future economic growth, changes in fiscal and foreign trade deficits directly affect the exchange rate. In addition, the foreign exchange market participants' expectations have a significant impact on the value of the exchange rate. Seasonal peaks and downs of business activity in the country have a significant impact on the rate of national currency.

Factors that affect currency rates


Exchange rates continuously fluctuate, there are several factors such as interest rate expectations, inflation, macro economic risks and events.

Short-term factors

Interest rates: a government may decide to lower interest rates in an attempt to stimulate growth in the economy. Generally, this means that investment funds will flow out of one currency into another currency that has higher interest rates. So when looked at in isolation, lower interest rates could weaken the currency.

Trade flows: a trade surplus is where there is a greater demand for goods and services from a country, which means its currency (needed to pay for those goods) will be stronger. Conversely, a trade deficit will usually weaken the currency.

Natural disasters: think about the earthquakes in Japan and New Zealand and the effect this has had on their currencies. The currencies initially weakened on the events due to the unknown damage made to the economy. They then strengthened as insurance funds and other sources of funding flowed back to these countries from overseas to fund the repairs. Then the currencies weakened due to action taken by their central banks to aid economic recovery, such as injecting additional funding into the financial market and reducing interest rates, had a negative impact on the currency.

Economic growth: an investor may choose to hold one currency over another simply because that country is growing at a faster pace than the other or is perceived to do so in the future. Links to commodity based currencies: currencies such as Norwegian Krone or Canadian dollar are commodity linked currencies and their exchange rates tend to increase in value when there is a rise in commodities such as oil. Conflict: there may be a period of time where there is no official government in place or when a person or organisation has taken power illegally. This will naturally have an effect on the currency and will be ongoing as the conflict continues.

Short term inflation: if inflation is starting to rise then the natural response for the authorities will be to limit the rise of inflation by increasing interest rates, therefore clients may convert into that currency in anticipation of gaining a better return on their money.

Long-term factors

Long term inflation: this is a rise in the general level of the prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services. Consequently, inflation wears away the purchasing power of money in that country. So higher inflation in a country typically weakens its currency.

Economic growth: it can take many years for an economy to recover i.e. the subprime crisis in the US took place over three years ago, and it has taken many years for the US economy to recover to the level it's currently at.

The main factors affect the exchange rates


All foreign exchange involves a nations currency to exchange another kind of currency. At anytime, the actual exchange rate mainly decided by the corresponding currency supplies and the demand. With regard to the demand for currency means that another supply of currency. Similarly, when you provide one kind of currency also means that the demand for another currency. The following factors affect the supply and demand of the currency, thus produced the effect of exchange rate. 1Monetary Policy When central banks had been intervening in foreign exchange markets and the result is consistent with the governments monetary policy, the central bank will participate in foreign exchange market. The involvement of the central bank is usually to buy or sell the currency to the stability of the currency in a being that is real and an ideal level. Other participants in the market anticipated that the influence of monetary policy will controls the supply of currency, and often targeting a rate of currency. 2Political situation Fluctuations in exchange rates are usually caused by the global situation tend to intense. Some currency unusual inflow or flow out, the exchange rate will be large undulation. Political stability is relate to currency stable, we can through some examples to prove that how the political affect the exchange rate. The end of 1987, some countries tried to maintain the basic stability of the dollar exchange rate because of US dollar depreciation. Seven western countries financial ministers and central bank issued a joint statement in December 23, 1987. They started intervening in foreign exchange market in January 4, 1988. Then, sold a great deal of the Japanese yen and Deutsche Mark changed the purchase of U.S. dollars. Another example, if you are concerned about the Euro, you must have noticed during the war in Kosovo. For 3 years, the rate of exchange between Euro and USD is fell by 30%, one of the reasons is the war in Kosovo influence over on the Euro. 3Balance of payments A country's international balance of payments situation will lead to its currency exchange rate fluctuations. Balance of payments is a summary of all residents of one country, foreign economic and financial relations. Also, all factors reflect the countrys economic status in the international arena, but also affect the country's macro and micro economic operation. An economic transaction, such as export or capital transactions (such as foreigners in their own investment) gave rise to the income of foreign exchange. Because foreign exchange is usually can not using in the local market, so it is necessary to convert foreign money to domestic. This creates a supply of foreign exchange on the market. An economic transaction, such as import or capital transactions (foreign investment) is caused by foreign exchange expenditure. Because it must exchange foreign currency to the domestic currency and meet respective economical needs, then produced in the foreign exchange market to the foreign exchange need. Synthesizes these transactions, writes down in the international payment balance statistical table, then constituted a country's foreign exchange revenue and expenditure condition. If the foreign exchange earnings are bigger than the disbursement, then the foreign exchange supply increases; if the foreign exchange disbursement is bigger than the income, then increases to the foreign exchange demand. The foreign exchange supply increases, in the demand invariable situation, urges the foreign exchange directly the price drop, the standard currency value on the corresponding rise; when the foreign exchange demand increases, in the supplies invariable situation, urges the foreign exchange

directly the rise in price, standard currency value corresponding falling. 4Interest rate When a countrys leading interest rate is rise or drop in another country, it will be pursue the higher retaliate on fund, the low interest rate currency was sold, but the high interest rate currency is buying. Because relative high interest rate currency demand has increased, therefore this currency will revalue to other currencies. Let see an example explain how the interest rate does affect the exchange rate There are country A and country B, both countries do not execute the foreign exchange control, the fund is free flowing between two countries. As a A country monetary policy part, an interest rate of this country had been rises 1%. Simultaneously the B country's interest rate level is invariable. A amount of floating capital into market, the fund will supply with a loan at the most favorable rate between nations. But when other conditions invariable A country's leading interest rate upward, the large amount shortterm floating capital can flow in the A country to pursue a higher interest rate. When the floating capital flows out from the B country, the large amount B country currency is sold exchanges the A country currency. Like this regarding the A country currency demand rise, its result is A the country currency relative B country currency walks strongly. The point of the example is situation regarding both countries between. In fact, the market became internationalization today, it similarly practical in global. For years, the fund free flowing and the foreign exchange control elimination has been ultimately. This trend is the free flow of international short-term hot money (sometimes called "hot money") provides a great convenience. There is a noticeable that only when the investors that the exchange rate movements do not offset the return of the high interest rates, funds transferred to the high interest rates of regional or national. 5The market judgment The foreign exchange market always does not follow a logical change. Factors that difficult to understand including personal feelings, the judgment, the analysis for various global politics , economical event, understanding the impact of exchange rate. The market operator must correct understanding of a variety of published reports or data, such as foreign exchange income and expenditure data, indicators of inflation, economic growth rate. But in fact, before reporting a data to the open market, there will be a data reflection true expectation or judgment in the market. This expectation or judgment will be report in public and the data reflected in the price. If appears the real report either the data and the people anticipated the wide difference, it will lead to exchange rate fluctuation. The only correct understanding of the various economic indicators and data is not enough for a foreign exchange dealer. He must understand what expected and judge of the market indicators and data on unpublished. 6Speculation Speculation of the market operator also is an important factor affecting the exchange rate. The percentage of the transaction direct and the international trade in the foreign exchange market is not high on the other hand. Most of the transactions from the essence are the congenial behaviors, congenial behavior will cause the different currency the flowing, thus will have the influence to the exchange rate. When people analyze the factors of exchange rate to obtain some kind of currency exchange rate to rise, the competition rushed to purchase, then became this currency rise the reality. Otherwise, when the people anticipated some currency will fall, will be able to compete to undersell, thus will cause the exchange rate to glide down. For example, after the World War II period of time, politics of United States stability progressively, the economical movement is good and the inflation rate is low, but the economy grows in the beginning of the 60's reaches yearly average 5%. The various countries willing to take the U.S. dollar as a means of payment, store of wealth, so that the U.S. dollar exchange rate to rise continually. However, the early 1970s to the late 1960s, because of the Vietnam War, Watergate scandal, serious inflation and increase the tax burden, the trade deficit and economic growth have declined, so that the value of the dollar fell sharply.