Factors Which Can Influence Exchange Rate Movements - Coursework Example

Name: Professor: Course: Date: Introduction Exchange rate is the price a country’s currency expressed in terms of another currency. The two countries most probably have trading relations. The exchange rate in a way is used to determine the economic strength of a country by measuring the value of the countries currency. The exchange rate is influenced by several factors chief among them interest rates and economic conditions (Tauline, 2008). It is vital that the value of a country’s currency is maintained as high as appropriate depending on the prevailing conditions or as low as necessary depending on the desired outcome. The central banks all over the world are tasked with ensuring exchange rate stability in their respective economies through various strategies (Nier, 2009). This paper is intending to discuss several factors influencing exchange rates and also strategies adopted by the Reserve Bank of Australia in the foreign exchange market in comparison to those adopted by the Federal Reserve of the US. Factors which can influence exchange rate movements Interest rates Over the past few years interest rates have emerged as a very important factor that influences interest rates in countries’ economies. There exists an interrelated relationship between interest rates, inflation and exchanges rates. Central banks manipulate interest rates to influence inflation rates and exchange rates. A higher interest rate in a country in relation to other countries will mean that the investors in that particular country are earning a higher return on their deposits than in the country with lower interest rate. The implication of this is a higher demand for the currency of the country with the higher interest rate causing the exchange rate of that country to rise. On the other hand lower interest rates will decrease exchange rates. Central Banks use this technique to influence the exchange rates in order to achieve desired the economic performance depending on the prevailing conditions of the respective economies (Ellis, 2001). Balance of payments Balance of payments is a summary analysis of a country’s trade with its trading partners. It covers tangible goods and services that a country exports and imports as well as the financial transactions between the country and the world countries. It has the potential of influencing the macro and micro economic operations of the country. When a country exports goods or receives foreign investment in form of foreign currency it has to transform the foreign currency into the domestic currency for it to be allowed to circulate. This scenario increases the supply of foreign currency in the market. This means the exchange rate is high. If a country on the other hand imports or experiences massive outflow of investment, it will result in foreign payments. The country is forced to convert the domestic currency into foreign currency. There is an increased demand for foreign currency in the market. The increased demand will lower the exchange rate. Since the demand for foreign currency is high but its supply remains constant and vice-versa for increased supply of foreign currency (Ellis, 2001). Political environment Politics most definitely affect every spheres of life in a country. The economy of a country is closely linked to its political situation; countries with thriving economies will also reflect a high level of economic stability. A country with an unpredictable political environment is very likely to experience irregular inflow and outflow of currencies especially when it comes to foreign investment. Investors are unlikely to channel their money into a country that shows signs of deteriorating into unmanageable political situations; instead they will choose to invest in a country with a stable and predictable political environment which also affects its macro and micro economic situation. The result will be a low supply of foreign currency in the country with unstable political environment and therefore a low exchange rate. Unstable political environment will also reduce the productivity of an economy meaning the level of exports will reduce and as such reduce the foreign currency being earned by the exports which will in turn lower the exchange rate (Tauline, 2008). Speculation The transactions between two countries may be economical in the sense of trade or financial in the sense of currency movement. The later is the most common, trading activities are mostly lower than financial transactions. Most of the financial transactions are influenced by speculative trading and among other factors such as interest differentials. Speculative trading occurs when operators in a foreign exchange market predict a rise in value of a certain currency. The implication will be an increased demand for the currency and thereby increasing the value of the currency. On the other hand if the value of a currency is expected to go down, operators will hurry to sell it away to avoid making losses thereby depreciating the value of the currency. These two phenomena are caused by speculations in the market basing on a number of factors including cycles in an economy. They have a profound influence on exchange rates and can actually cause a great economic problem if not well controlled (Tauline, 2008). Government debt It is common for governments to engage in debt financing by selling issuing bonds to finance huge public projects and government expenditures. If unchecked these activities may put the government in a situation where the public debt arising from these bonds is very high. A country with huge public debt is less attractive to investors as the debt results in rising inflation which will lower the value of the domestic currency. The rising debt may also cause foreign investors to fear that the government may default on its debts; as a result the investors will sell their bonds to recover their investment before matters get worse. This will cause a decrease in exchange rate as the value of the domestic currency plunges. It is therefore very important that governments keep a close look at the public debt so that it may not rise so high to discourage foreign investors (Nier, 2009). Monetary policy and government intervention Monetary policy is procedure adopted by the monetary authority in a country to determine the supply of money. Central banks will engage in buying and selling of the domestic currency to stabilize its supply and demand in the market to levels that the government deems ideal for the economy. This in turn affects the interest rates in the country since the government is directly involved in the foreign exchange market. The scenario has a considerable effect on exchange rates since the monetary policy and predictions of the government future actions are very well monitored by foreign exchange market players. Some governments also directly influence the exchange rates by lowering or increasing the value of their currency to influence trading activities (Ellis, 2001). A case in point is china which has been accused by US government of undervaluing its currency in order to keep its exports more competitive. A strong Chinese currency will be difficult to buy by importers in other countries and as such may cause china’s exports to be less competitive in the global market (Nier, 2009). Strategies adopted by the Reserve Bank of Australia in the foreign exchange market The reserve bank of Australia (RBA) operates as the central bank of Australia. The bank’s operations are guided by the Reserve Bank Act 1959. The main duty of the bank is to ensure stability of the Australian currency, full employment in Australia and economic prosperity as well as the well being of Australians. Among other duties the bank is tasked with ensuring a stable exchange rate by intervening in the foreign exchange market through adoption of various strategies to help it achieve its objectives. RBA regularly engages in foreign exchange market intervention since the floating of the Australian dollar (Dominguez, 1998). The intervention is normally in form of buying and selling the Australian dollar against another currency. The dollar is mostly the currency against which most world currencies decide to sell or buy their currencies; Australia is no exception. Below are two most common ways the bank intervenes in the foreign exchange market as compared to those adopted by the US. The first strategy is achieved by varying the interest rates in Australia. From our discussion above, it is evident that when interest rates are high in a country; it is highly likely that capital transactions involving massive cash inflow will occur. The RBA regulates the interest rates in the country by regularly reviewing the base lending rate which determines how much interest the banks are paying the central bank to get the Australian dollar. The effect is that the banks have limited financing due to the high base lending rate. They have to source for money from the market by encouraging deposits. Deposits can only be encouraged by increasing the interests realized from deposits. If investors are promised of a higher interest rate by depositing money in Australian banks then they will channel a lot of their capital to Australia and thereby raising the exchange rate (Becker & Sinclair, 2006). The reserve bank can also enter the broker market by dealing on other banks offers or bidding directly in the market. This strategy is used when the bank wants to announce its presence in the market. The market is where the banks trade and the actions of the central bank which is the major player in the market is enough to influence the exchange rate depending ton the actions and the bids and offering put forward by the bank. It in a way communicates the reserve bank’s policy position regarding the exchange rate. The reserve bank may opt to deal directly with the banks in a two way quote whereby it can either give the bank’s bid or pay the bank’s offer. The effect of this is that the banks will adjust their quotes to compensate for the eminent loss in the currency that the reserve bank is trying to sell; the adjustment is usually upwards since the reserve bank is dealing with other banks in the sector too. The adjustments have an effect on the exchange rate depending on which currency the reserve bank is intending to buy. If for example the bank is intending to buy the Australian dollar by selling the US dollar there will be an increased supply of the US dollar and thereby increasing the value of the Australian dollar (Becker & Sinclair, 2006). These strategies are also used by the Federal Reserve System which is the US central bank. The bank uses several strategies to influence the supply and demand of money in the US so as to accelerate economic growth and also absorb shocks in the economy. The Federal Reserve System varies interests depending on the outcome that is desired it also engages directly in the foreign currency market to influence demand and supply of foreign currencies in US and beyond (Nier, 2009). Conclusion In conclusion, there is a multiplicity of factors that affect exchange rates all over the world, the main factors being interest rates and trade between two trading partners. The foreign exchange market is a volatile market that requires being monitored by regulatory authorities in respective countries. The central banks are charged with ensuring they adopt strategies to have positive influence on exchange rates. They may involve interest rate manipulation of direct trading in the foreign exchange market. The efforts are aimed at stabilizing the exchange rate. The reserve bank of Australia is charged with this ask as it is the central bank of Australia. References Becker, C., & Sinclair, M. (2006). Profitability of Reserve Bank Foreign exchange operations: twenty years after the float. International Department, Reserve Bank of Australia, Research Discussion Paper. Dominguez, K. M. (1998). Central bank intervention and exchange rate volatility. Journal of International Money and Finance , 17, 161-190. Ellis, L. (2001). Measuring the Real Exchange Rate: Pitfalls and Practicalities. Reserve Bank of Australia, Research Discussion Paper. Nier, E. (2009). Financial stability Frameworks and the Role of Central Banks: Lessons from the Crisis. International Monetary Fund. Tauline, M. J. (2008). Exchange Rates: Dynamics, Expectations and Adjustment. Nova Science Pub Incorporated. Read More