What factors determine and intervene in foreign exchange rates?

Explain your arguments

by providing relevant theoretical/ empirical literature and use relevant data

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Abstract

Various factors affect foreign exchange rates, and the elements have both sides effects whereby

they will have an impact in a particular manner in the local setting. At the same time, in the

foreign one, they will also have some effects. Besides, there are interventions done by the central

banks in the foreign markets, and they are geared towards achieving something beneficial to the

economy. The interventions are promising but need to be done smoothly, not rendering the

enacted policies used. The independence and strength of separation of the central bank and the

government can be crucial in strengthening the foreign exchange markets. The central banks can

keep the economy off the bad decisions that the political elites can make. The factors considered

are interest rates, inflation rates, government controls, relative income, and speculations. The

elements are dealt with separately as their effects are different and independent, although some

have some minor similarities. The central bank's intervention also helps deal with foreign

exchange rates as they prevent crises, bringing an external balance that boosts growth and

control of inflation, which maintains the internal balance.

Introduction

There are effects of exchange rate movements on the trading relationships with other countries.

A high-value currency makes a particular country's imports less expensive and makes the exports

more expensive in foreign markets. A currency with a low value makes the imports to a country

very expensive, and the exports are made very expensive in the same foreign markets. A higher

exchange rate can be expected to worsen the country's trade balance, while when there are lower

exchange rates, the same can be improved.

The intervention of the Central banks in the foreign markets has evolved for a long time and thus

has helped achieve maturity. The intervention has declined in several countries while others, like

the Japanese, still intervene. The intervention of central banks is because of a few reasons. It

primarily aims to achieve overall economic objectives, such as controlling inflation, maintaining

competitiveness, and financial stability (Ilzetzki, Reinhart, and Rogoff, 2019). The purposes of

the intervention policies depend on several factors, for instance, the extent of integration and

financial market development, the stage of development of the country, and the overall shock

vulnerability of the country. The three most essential and immediate interventions have been the

level of exchange rate influence, dampening the exchange rate volatility, and the power of the

market reserves.

Literature Review

Several factors influence exchange rates, as has been explained by several scholars, such as

government controls, inflation, interest rate differentials, differences in the income level, and

changes in the level of expectations.

According to Fratzscher et al. (2019, pp.132-156), the shifts in the relative inflation rates affect

the trade activity. This influences the demand and supply of the currencies, which trickles down

to affecting exchange rates. Countries that have lower inflation rates tend to have an appreciated

value of their money. For instance, the appreciation, which is long-term between Germany and

Denmark in the period after the war, had a relationship with the lower inflation rate. The last half

of the 20th century saw countries like Switzerland, Germany, and Japan having the lowest

inflation rates. The United States of America and Canada achieved this later on. Two firms from

different countries sell substitute goods to one another, for instance, the US and Japan. If the

inflation in the US increases and that of Japan remains the same, the demand in the Us for goods
from Japan will increase, causing a demand rise in Japan; thus, the need for Yen in the US will

rise. The market for US goods in Japan will go down, reducing the supply of the dollar. The

opposite will still occur if the inflation in Japan increases and that of the US remains the same.

Engel (2016, pp.436-74) mentions that the interest rates also affect the foreign exchange rates

whereby investing in the foreign securities is affected by the shift in the demand and supply of

whichever currency and the subsequent exchange rates. If the interest rates take an example of

the United States of America, there will be a better return on the savings in the UK savings

account. For instance, people who have kept their money in the foreign UK savings account will

receive more profits, and thus, this will encourage even more investors from outside and the

domestic ones to save more, thus increasing the flow of money in The UK. With more money

being deposited, an advantage is achieved in the UK market and foreign countries, increased

demand for the US dollar, which is the currency of the United States. The demand will lead to an

appreciated value of the dollar. Therefore, the need for particular money shows its value, which

is contributed to by the interest rates implemented or prevailing in a country in a specific time

(Alagidede and Ibrahim, 2017, pp.169-193).

Kim and Sheen (2018, pp.3-41) investigated that relative income also influences the exchange

rate as it affects the demanded amount of import and exchange rates. Take an example of the UK

and US as A and B respectively, where income level in A increases and the income level in b

remains constant. This will result in the shift in the demand curve upwards as a result of the

increased level of income in A and the demand that has increased demand for goods from B. the

schedule of supply is not expected to change, and this leads to a rise in the exchange rate at

equilibrium. The lack of change in the collection program will lead to an appreciation of the

exchange rate. When the vice versa, and there is a decrease in the income level in A and the
income in B is not changed, the demand of goods from B by A will reduce. This will cause a

downward shift in the demand curve.

The government controls also have a way in which it handles the exchange rates in a couple of

ways. The government plays an essential role in many of the factors that have been mentioned to

affect the exchange rates. Some foreign governments literally can impose them to the markets,

which means all businesses, whether local or foreign, will have to abide by them (Aizenman,

Chinn and Ito, 2016, pp.298-330). For example, the exchange rates, income trade barriers with

foreign countries, amongst many other factors. For instance, the rise in the exchange speed in the

UK and US remains the same, and there would be an increase in the supply of a dollar. With the

government's imposition of a high tax on the interest rate income from foreign investments, there

will be a discouragement for the investors to exchange the dollar for the Pound. This will

increase demand, or there will be no change in the market; thus, there will be an influence in the

opposite direction. An example of government control is seen in the People's Republic of China,

which has decided to keep its currency undervalued to ensure that the exports from the country

remain competitive. This is achieved by pursuing assets in US dollars, which leads to an increase

in the value of the US dollar to the Chinese Yuan.

In his study, Cavallino (2019, pp.127-70) stated that most institutions and sectors worldwide

have a way to react to news and other information from media outlets due to changes in the

ordinary being of the sectors. The financial markets and foreign exchange markets are not left

out in this, and it causes effects in the future depending on how the institutions react. The result

is two ways; for instance, it can cause either a decrease or an increase in the exchange rates.

News of increased inflation in a country spreading can cause traders to sell the currency of the

particular nation and thus increase its supply, but there will be no impact on demand. This will
result in decreased supply, and thus the exchange will reduce as well. When the vice versa

happens, many investors will buy the currency, and the demand will increase, but the supply will

have no change; therefore, an increased equilibrium exchange rate will be realized (Bech and

Malkhozov, 2016). The movements in the exchange rates are always reflected in the economic

fundamentals, but they are driven mainly by the ideas and sentiments of the financial markets. A

good example is the fall of the British Pound, which related to the British exit from the European

Union. Many investors thought that the UK would not attract more inflow of capital from the

single currency.

Other factors like national disasters or unexpected events, such as cyclones, tornados, and floods,

can happen many times without information. The current disaster is the COVID-19 pandemic

which ravages the entire world. These pandemics and natural calamities have adverse effects on

the economy and the people at large for example can cause food shortages and even loss of lives.

The currency of the nation facing a crisis always weakness and thus, the foreign currency

becomes more demanded, which causes changes in the exchange rates to a lousy level for a

country. The Covid-19 had real adverse effects on the foreign exchange markets. The imposition

of lockdown by different countries hindered the free flow of business and other goods and

services, which has caused a severe breakdown in economic growth. The Rohingya crisis also

brought more pressure on imports and food which led to the affected price of the currency. The

trade markets, both domestic and international, stagnate, and the global supply chain is faced

with severe challenges. This creates volatility in the freeing exchange market, which increases

pressure on the country's economy (Arbatli et al., 2017).

Interventions to influence the level of the exchange rate has been seen in many regimes since the

early 1990s; the emerging market economies managed the exchange rates. This was intended to
keep the level of exchange rates at specific rates of having a limit on the fluctuations of the

prices in the different economies (Moagăr-Poladian, Clichici, and Stanciu, 2019). In countries

like Hong Kong and Bulgaria, foreign exchange operations support a peg under board currency

management. Many economies in East Asia maintained the basket pegs. The official sectors

target the exchange rates for three fundamental reasons: controlling inflation or maintaining

internal balance. The management of inflation has been done using the exchange rate as the

nominal anchor for the monetary policies. The regimes of high inflation in Brazil were ended by

the quasi-fixed exchange system, while in Argentina, the currency board adoption was used for

the same purpose. There has been a decline in nominal anchors in control of exchange rates, but

China still sees it as necessary to liberalization its exchange system. Israel and Singapore have

also used exchange rate paths to control inflation or support monetary policy (Chen, Du, and Hu,

2020). Secondly, the achievement of external balance and boosting growth and enhancing

competitiveness. The targets of exchange rates have been used to prevent the misalignment of

the real exchange rate and the achievement of the external equilibrium. The goal has always been

to avoid genuine exchange rate appreciation, and the huge deficits in accounts that can be seen as

unsustainable could reverse suddenly. Thirdly, the prevention of crises, in case there are

mismatches in the currency in a particular economy so that the foreign liabilities are not backed

entirely by the assets of the foreign currency, a depreciation of the coin would affect the financial

position of firms which borrow money in foreign currencies (Nusair and Olson, 2019, pp.44-63).

If the depreciation is large enough, it could weaken the financial sector and trigger a financial

crisis in these conditions.

Analysis and recommendations

There are many factors that play different roles in the foreign exchange market to make sure that

there is a smooth flow of operations. Others also bring in challenges that must be worked on very

well to prevent failure and stagnant economic growth. The inflation rates of the countries have to

be carefully analyzed so that the effects will favor the particular investor who wants to venture

into some business in the foreign markets. Inflation rates should be kept at the lowest most times;

this would be very helpful in the strengthening of the currency of a country. A stable currency

calls for more demand from foreign investors, and this ensures that there is economic growth as a

factor that plays an essential role in the operation of exchange rates must be adequately checked

to avoid causing a surge in the supply of currency which in turn renders it unattractive for

foreign investment (Aslam et al., 2020).

The central banks play an important role in ensuring that there is little money supply for inflation

to be retained at the low levels. The intervention of the central bank is also significant in

reducing extreme inflation conditions, which would otherwise cause a crisis in the monetary

policy (Rebucci, Hartley, and Jiménez, 2020). The soundness of the central bank should

therefore be upheld as it helps in having economic policies which ate very good and beneficial to

the economy. The central bank's independence is also essential, and working from its own space

would help in the aversion of the effects of short-sighted economic or political influences that are

not helpful to the economy. The purchasing power of a currency is significant in the foreign

exchange markets as it helps in the stability of the nation's economy.

Government control has been one way in which the foreign exchange markets have been

effectively managed and controlled. This has been done in several countries that have been

successful after implementing some controls in the foreign markets. Countries like Hong Kong,

the United States of America, China, and Australia have been beneficiaries of the government's
control of the foreign exchange markets (Albagli et al., 2019, pp.447-473). Although many

governments have stopped implementing controls in the foreign markets, some continue, and

they have realized continued growth through it. Japan still uses the control systems and China,

although it has focused on ensuring that the foreign exchange markets work in their favor

through their weakened Chinese RMB against the US dollar. Most of the government controls in

the foreign markets are geared towards the protection of the local markets, which many investors

would prefer to come and do business with. They ensure a fast-growing GDP and many

opportunities for investments that will attract more capital and thus a realization of higher

currency values. The interventions of the central banks are also a good way of keeping the

foreign exchange rates in favor of the host countries (Albagli et al., 2019, pp.447-473). They are

vital in the prosperity of the local markets and protect them against the bad effects of inflation by

creating effective monetary policies for the sectors to enjoy.

The recommendations for the interventions of the foreign exchange rates should be;

i. The intervention policies by the Central banks should be objective and precise; this

will include two essential aspects, which are; the specification of the exchange rates

to be used and the selection of the target of the exchange rate. The measures of the

exchange rate may entail nominal effective, real bilateral, nominal bilateral, accurate,

effective exchange rates.

ii. The detection of the illiquidity in markets should be done using three essential

indicators: the acceleration in the pace of the changes in the exchange rates, the

increases in the rate of volatilities, which are unwarranted and sharp changes in the

composition and level of turnover. The three would help in achieving effectiveness in

the intervention.
 iii. They should constantly be assessing the interventions aimed at addressing the levels

of exchange rates in the context of the macroeconomic policy mix, the nature of the

shocks to the economy, the extent of dollarization, and capital mobility.

iv. The central banks should have some degree of discretion in determining what

amounts and when to make the interventions. The control will allow the central banks

to accommodate the market conditions, and thus there is room for tactical maneuver.

v. The government should be quick to intervene in the foreign exchange markets in case

of natural disasters like the Covid-a9 pandemic; this would help in getting the country

back to its economic growth

vi. The market intelligence should be vested in more for the understanding of the market

indicators, and this will be to help in doing away with the economic effects of

speculations and assumptions from the news which laws brings panic in the exchange

rates

Conclusion

The demand for a particular currency shows its value, and this is contributed to by the interest

rates that have been implemented or that are prevailing in a country at a particular time. The

relative income also influences the exchange rate as it affects the demanded amount of imports

and exchange rates. Lack of change in the schedule of supply will lead to an appreciation of the

exchange rate. With the government's imposition of a high tax on the interest rate income from

foreign investments, there will be a discouragement for the investors to exchange the currencies.

The movements in the exchange rates are always reflected in the economic fundamentals, but

they are driven mainly by the ideas and sentiments of the financial markets. The control of

inflation has been done using the exchange rate as the nominal anchor for the monetary policies.
News of increased inflation in a country spreading can cause traders to sell the particular nation's

currency and thus increase its supply, but there will be no impact on demand. The regimes of

high inflation in Brazil were ended by the quasi-fixed exchange system, while in Argentina, the

currency board adoption was used for the same purpose.