FACTORS THAT INFLUENCE EXCHANGE RATES

e= Percentage change in the spot rate (%)

INF= Change in the differential between U.S. inflation and the foreign country’s
inflation
INT= Change in the differential between the U.S. interest rate and the foreign
country’s interest rate
INC= Change in the differential between the U.S. income level and the foreign
country’s income level
GC= Change in government controls
EXP=Change in the expectations of future exchange rates
e= f (INF,INT,INC,GC,EXP)
RELATIVE INFLATION RATES
Changes in relative inflation rates can affect international
trade activity, which influences the demand for and supply of
currencies and therefore influences exchange rates.

RELATIVE INTEREST RATES

Changes in relative interest rates affect investment in foreign
securities, which influences the demand for and supply of
currencies and therefore influences exchange rates.
REAL INTEREST RATES
Although a relatively high interest rate may attract foreign inflows ( to
invest in securities offering high yields), the relatively high interest rate
may reflect expectations of relatively high inflation…..
Real Interest Rate= Nominal Interest Rate – inflation rate
This relationship is sometimes called the fisher effect.
RELATIVE INCOME LEVELS
The third factor affecting exchange rates is relative income
levels. Because income can affect the amount of imports
demanded, it can affect exchange rates…..
GOVERNMENT CONTROLS
The governments of foreign countries can influence the equilibrium
exchange rate in many ways, including (1) imposing foreign exchange
barriers,(2) imposing foreign trade barriers,(3) intervening (buying and
selling currencies) in the foreign exchange markets, and (4) affecting
macro variables such as inflation, interest rates, and income levels.
EXPECTATIONS
Like other financial markets, foreign exchange markets react to any
news that may have a future effect. News of a potential surge in U.S.
inflation may cause currency traders to sell dollars, anticipating a future
decline in the dollar’s value. This response places immediate downward
pressure on the dollar……