Exchange rates refers to the rate at which a particular country’s currency trades against
currency belonging to another currency on a foreign exchange market. The rate of currency
exchange tends to reflect the position of a particular nation in the background realm of world
economy (Stein, & Allen, 2017). Besides, the rate of currency exchange in relation to currencies
DETERMINANTS OF EXCHANGE RATES 3
belonging to other nations reflects the unit price of currency that is beings used and expressed in
terms of another currency. Arguably, it expresses the country’s currency of fiscal unit price of
the overseas nations.the exchange rate of currencies play a significant role in determining ,
assessing as well in reassing country’s economy in the world market(Barbosa etal,2018).
Notably, exchange rate of currency is considered as apivotal tool not only in connecting
economy of a particular Nation with that of the rest of the world but also in transmitting
monetary, policy and economic changes.
Usually, the level of exchange rate represents a significant element of credibility of
monetary system in a particular nation. Therefore, it is regarded as essential macro-economic
factor in the formulation of monetary policy. In addition, any crisis related to currency indicates
how exchange rates can significantly impact economic developments of particular Country.
Currency crisis may occur as result of excessive external borrowing thus exposing country to
foreign exchange risks(Stein, & Allen, 2017). Notably, exchange rates play a crucial role in
assessing and reassessing economy of a particular country.it is therefore, considered not only as
an essential tool which connects economy of particular country with the rest of the world but also
as an important tool for transmitting monetary policy and changes in economy. This paper
therefore, seeks to examine determinants of exchange rates.
Determinants of exchange rates
There are several factors which influence exchange rates including;
Inflation rate is one of the determinant of exchange rates. In this case, any changes in the
comparative rate of inflation is likely to impact significantly the global trading activity, thus
DETERMINANTS OF EXCHANGE RATES 4
affecting the demand and supply of currencies and hence, influencing exchange rate of
currencies (Georgiadis, 2016).For instance, if the inflation rate of United States of America hikes
and that of United Kingdom remain the same, the is high probability that British exports will
become more competitive thus resulting to increased demand for british commodities and
therefore, the US aggregate demand for the UK currency will increase tremendously. Besides,
increase in the inflation rate in US likely reduce demand for US goods in UK.Hence, there is
greater need to reduce the supply of pounds available for sale hence putting an upward pressure
on the Pound’s value.
Inflation determines currency exchange rates by influencing the level of price changes. In
this regard, countries with high inflation rates experience currency devaluation.Basically, high
rate of inflation inextricably linked to currency devaluations simply because commodities tend to
become more expensive by reducing their demand. Therefore, inflation is strongly connected to
exchange exchange rates (Mueller etal,2017). Increase in the inflation rate within a particular
country tends to increase exchange rate. This is because inflations tends to increase supply of
money within a particular country’s economy and thus, forcing exchange rate of currency to
DETERMINANTS OF EXCHANGE RATES 5
The figure1: from the figure above, if the inflation rate of US dollar exchange rate
increases, the aggregate demand of Mexican dollars currency will also increase tremendously.
In addition, Interest rates is also an important factor that determines exchange rate of
currency. Any changes in the comparative interest rate tends to influence significantly
investment particularly on foreign securities traded in the stock markets. Changes in the relative
interest tends to influence demand and supply of currencies and thus determining exchange rates
(Mueller etal,2017). For instance, if United States of America increases its interest rates while
the british intrest rates remain the same. In this regard, the aggregate demand for British pounds
is likely to decline, simply because the Interest rates in US are more attractive to foreign security
investors and therefore, there will be less demand for the British Bank deposits. In this case, the
suppy of pound being sold by british investors should be increase in order to establish more bank
deposits in US. In most cases, this is perceived as inward shift in the aggregate demand for
British pounds and an outward shift in the supply of pounds available for sale and therefore,
DETERMINANTS OF EXCHANGE RATES 6
exchange rate is likely to reduce.Occasionally, changes in the rate of intrest in the developing
countries is likely to impact significantly currency exchange rate between two nations. For
example, if interest rates in Canada increase, it becomes more attractive to investors from UK
when compared to rates in US . in this regard, supply of british pounds to be traded for traders
will be lesser thus putting an ascending pressure on the value of pounds compared to US dollar.
Figure 2: Showing relationship between interest rates in UK and United States.
Relative Income levels is another important determinant of exchange rate. The relative
income level of particular nation tends to influence the demand of goods or services to be
imported thus affecting the exchange rate of currency (Waryati etal,2019). For instance, if
income levels in United states of America increase and income levels in Uk remain the Same.
This scenario will basically depict three circumstances:i) the aggregate demand for british
pounds will outward indicating an increase in the US income levels and there will be increased
DETERMINANTS OF EXCHANGE RATES 7
demand for goods imported from UK., ii) the supply of british pounds available is expected not
to change, iii) The exchange rate of british pound currency will increase.
Balance of payments
The Balance of payments is also another important economic variable that is likely to
influence exchange rate of currency of a particular country. Increase in deficit levels or balance
of Payments determin devaluation or depreciation of local currency while on the other hand,
decrease in Balance of payments results in the appreciation of local currency (Waryati
etal,2019). For instance, the current BOP in US of 7% GDP was the main reason for the
depreciation of dollar between the year 2006 and 2007. The balance of payments or deficit level
consists of the current and capital account, its impact on the currency exchange rates is intricate
but sometimes it is reversed(Barbosa etal,2018). Therefore, trade deficits which generally results
to currency depreciation can be recoverd by capital inputs that are like to lead to local currency
Figure3: below shows UK trade and current BOP % of GDP
DETERMINANTS OF EXCHANGE RATES 8
Speculation is another factor that is likely to influence exchange rate of currency. In
most cases, speculators tend make profits through margins by trying to buy and sell currencies.
For example, if speculators believe that price of pound wil rise in the near future, they will make
effort to acquire more now in r to make more profit in the future. Increase in demand for british
pound will make its value to appreciate (Li, X., & Wang, 2017). It is imperative to understand
that shift in the exchange rate is not always determined by the fundamentals of economy but by
financial market sentiments.
Change in competitiveness
DETERMINANTS OF EXCHANGE RATES 9
Changes in competitiveness is another important factor that is likely to influence
exchange rate. Increase in the competitiveness of global markets tends to increase the long-run of
currency value. For instance, if UK goods and services become more more striking and
competitive this will definitely make the value of currency exchange rate to increase.
Relative strength of other currencies.
In addition,the strength of other currencies is another factor that is likely to influence
significantly the exchange rate and perceived to have vice-versa effect (Barbosa etal,2018). For
instance, the value of pound appreciated between the year 1999 and 2001 since Euro was perced
as a scrawny currency. Weak currency tends to provide plenty of benefits boosting the economy
of country by increasing exports thus increasing the competitiveness of nation’s goods thus,
increasing the aggregate foreign demand while at the sametime maintaining the demand of local
consumers. These benefits accruing from sale of exports leads to creation of more employment
opportunities, increasing consumer spending power and well as help in reducing country’s trade
deficits(Chen etal,2016). Also, weak currency leads to increase in foreign investments and
increase in tourism activities which generate more revenues for the country and also in creating
Productivity is another factor that is likely to influence exchange rate of currency. If a
specific nation is more productive than other countries, there is a high likelihood that the prices
of commodities will be more cheaper than prices of goods imported (Chen etal,2016). As a
concequence, the aggregate demand for local goods will increase and currency will be
overdeemed. The reduction of local goods prices in the country will result to increase in exports
thus causing currency evaluation.
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In conclusion, exchange rates refers to the rate at which a particular country’s currency
trades against currency belonging to another currency on a foreign exchange market. The rate of
currency exchange tends to reflect the position of a particular nation in the background realm of
world economy. In addition, the rate of currency exchange in relation to currencies belonging to
other nations reflects the unit price of currency that is beings used and expressed in terms of
another currency. There are several determinants of exchange rate including;inflation, interest
rates, income levels, Balance of Payments, Productivity,speculation, increase in competitiveness
and relative strength of other currencies.
DETERMINANTS OF EXCHANGE RATES 11
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