The Main Influences on the Exchange Rate of a Currency - Coursework Example

Exchange Rate Grade Introduction Apart from factors such as inflation and interest rates, the exchange rate is one of the significant determinants of the level of economic health in a country. According to Hill (2007), exchange rate is the nation’s price of a currency in terms of another currency mostly affected by international business. It has two components, a foreign currency and a domestic currency, and can be indirectly or directly quoted. Exchange rates play a crucial role in the level of trade of a country, which is vital to free market economy around the globe (Piggott & Cook 2006). Because of this reason, exchange rates analyzed, watched and manipulated economic measures by the government. Exchange rates are also useful when examined on a smaller scale: they influence the real return of the portfolio of an investor. There are several factors that affect exchange rates. Before we examine these factors, it is important to look at how exchange rate affects the trading relationships between countries. A lower currency is considered to make exports of a country cheaper and imports expensive in the foreign markets. A higher currency is considered to make exports of a country expensive and imports cheaper in the foreign markets. Hence, a lower rate of exchange will increase the balance of trade of a country while a higher rate of exchange is expected to lower it. The Main Influences on the Exchange Rate of a Currency There are several factors that have influence on exchange rates, and they are associated with the trading relationship between countries on a global level known as internationalization or globalization (Hill 2012). It is significant to understand that exchange rates are expressed as a comparison of two currencies from two countries. It is also significant to understand that these factors cannot be discussed in a specific order; similar to numerous aspects of economics, the significance of these factors is usually subjected to discussion. The following are discussed determinants that influence exchange rate between countries. Differentials in Interest Rates Exchange rates, interest rates, and inflation are all highly correlated. Central banks in manipulating interest rates can exert influence on both exchange rates and inflation, and altering interest rates influence currency and inflation values. Interest rates that are high offer lenders high return in an economy relative to other countries. For this reason, interest rates that are high attract a huge amount of foreign capital and result in a rise in the exchange rate. For instance, if the United Kingdom rates rise in relation to elsewhere, it becomes advantageous to credit money in United Kingdom’s bank. This implies that an investor will get better return rates from saving in a United Kingdom bank. Thus, the demand for Sterling Pounds increases. This implies that interest rates that are high have a tendency to result in an appreciation in the exchange rate. Differentials in Inflation A country with a constant lower rate of the inflation rate shows an increasing currency value, as its buying power rises in relation to other currencies (Sloman & Hinde 2010). It is typical for those countries that experience high inflation to see a reduction in their currency relative to the trading partners’ currencies. This is normally accompanied by interest rates that are high. For instance, in the event of the United Kingdom inflation is relatively lower than any other country, then United Kingdom exports will become competitive and there will be a rise in Sterling Pound demand to purchase United Kingdom goods. This implies that foreign goods will not be competitive in the United Kingdom and the citizens will purchase less imports. Hence, countries that experience lower rates of inflation are likely to see an appreciation in exchange rate currency value. Public and Government Debt Many countries will participate in big scale deficit financing in order to pay for a majority of government funding and public sector projects. Whereas such an activity stimulates the domestic economy, countries with large public debts and deficits are not attractive to investors who are foreign. This is due to large debt that inspires inflation, and if there is a high inflation, the debt will eventually be paid off and serviced with inexpensive real dollars in the foreseeable future. The government in the worst case scenario will print money to settle part of a big debt. However, increasing the supply of money certainly causes inflation. Furthermore, in the event a government cannot service its shortage through local means, then it will be required to intensify the supply of securities for the purpose of selling foreign investors, thereby reducing their prices. Lastly, the government debt value can influence exchange rate. If foreign investors fear the government of a country might avoid paying its debt, investors will certainly sell their bonds resulting in falling value of exchange rate (Mmieh 2012). Economic Performance and Political Stability Foreign investors certainly seek out political stable countries with excellent performance in the economy where to invest. These are known as positive business attributes, and a country that has these attributes usually draw investment away from countries that are thought to have more economic and political risks. Political mayhem, for instance, can result in loss of confidence in the movement of capital and currency as compared to other currencies that are from political and economic stable countries. For instance, the devastating civil war in Syria that has put the economy of the country on the edge of collapse, with closure of factories, rising unemployment, disrupted communications, and price hikes has been one reason for the fall of the Syrian pound (World Bank 2014). A country like this with both political instability and poor economic performance will result in lower confidence of investors, because of anticipated reduction in exchange rate that may lead to investors investing in other countries, rather than in Syria. Exchange Rate Regimes The factors discussed above have illustrated the influence on exchange rates from economic performance and political stability, public and government debt, differentials in inflation to differentials in interest rates. However, exchange rate regime is required to manage a currency of a country in order to ensure the influences discussed above on exchange rate are minimized, controlled or directed to yield specific desired outcomes. This regime is the way in which a country manages the currency in relation to foreign exchange market and foreign currencies. The most common types of this regime are fixed exchange rate, floating exchange rate and pegged exchanged rate. Let us examine these types of regimes and provide benefits and drawbacks. Fixed Exchange Rate Regime In this type of regime system, the central bank or government intercedes in the currency market for the purpose of making the exchange rate close to an expected exchange rate target. The central bank is powerless to affect exchange rate via monetary policy. Nonetheless, the central bank can utilize fiscal expansion to develop excess currency demand resulting in a rise in the output of domestic products. Then, the central bank will go on to buy foreign assets to raise the money supply and prevent the rising of interest rate resulting in an appreciation. As a result of these limitations, a country’s government having a fixed exchange rate will desire to control the currency amount that they allow in and out. This avoids any undesirable destabilization of a currency in the domestic country. There are benefits and drawbacks of fixed exchange rates. Let us start with benefits. The benefit of having a stable fixed exchange rate is to encourage investment. The uncertainty of fluctuation of exchange rate can significantly reduce the incentives for organizations to put their investment in export capacity. For instance, some firms in Japan have suggested that the United Kingdom’s unwillingness to join the Euro and provide a stable Eurozone exchange rate makes it a less desirable country to invest. There is however drawbacks of having a fixed exchange rate regime. One drawback is having less flexibility. It is hard to respond to short-term shocks. For instance, a food importer may face a balance of payments scarcity if food price rises, but in a fixed exchange rate, there is little devalue chance (World Bank 2014). Floating Exchange Rate Regime In this type of regime system, the currency value is influenced by everyday markets for demand and supply. Thus, capital and trade flow plays a huge role in the determination of a currency value. Two types of floating exchange rate systems exist: clean float and dirty float. In this regime, the exchange rate can be stabilized through both fiscal and monetary policy. Fiscal expansion leads to an appreciation of the currency that compels the government to purchase assets that are foreign. This increases the money supply stopping the appreciation of the currency. Through the monetary policy, when there is a surplus in supply of money, the government will purchase assets that are domestic for the purpose of weakening the currency and move down interest rate. Benefits and drawbacks exist when examining floating exchange rate regime. The first benefit is freeing internal policy. When looking at floating exchange rate, the balance of payments is rectified by an external price change of the currency. Nevertheless, with a fixed rate, taking care of the deficit can involve a deflationary policy leading to unpleasant concerns for the entire economy, such as unemployment. The government uses floating rate to pursue internal policy of their own like full employment without outside constraints (Mourmouras & Arghyrou 2000). The second benefit is flexibility. During the post 1973, there were big changes in the world economy due to OPEC oil disappointment. In this case, a fixed rate would have led to problems at this time as countries would not be competitive with the inflation rate they have. The floating rate, on the other hand, would allow a country to re-adjust flexibly to exterior disappointments or shocks. Even with benefits, drawbacks exist when looking at floating exchange rate regimes. The first drawback is uncertainty. Because the currency changes in value on a daily basis, it introduces uncertainty or instability into trade. Individuals who are selling may not be sure of the amount of money they will receive when they sell abroad. The rate changing will certainly affect the price and hence sales. Likewise, importers do not know how much the cost of importation will be given a specific amount of goods that are foreign. The second drawback is a lack of investment. The uncertainty discussed above may lead to a lack of investment abroad as well as internally. The third drawback is inflation. Floating exchange rate is considered inflationary. The floating can lead to inflation by permitting import price to rise as fall of exchange rate continues. This is, undeniably, the case for a country such as the United Kingdom where they are dependent on the importation of foodstuff and raw materials. Pegged Exchange Rate Regime This type of regime system is considered a hybrid of floating and fixed exchange rate regime. Usually, a country will peg its currency to a big currency, such as the United States dollar, or to a group of currencies. The government of China is known to be among many countries that pegged its currency to the United States dollar. With a pegged exchange rate, a first exchange rate is set and the actual exchange rate is allowed to fluctuate around the target first exchange rate. In addition, if there are changes in the fundamentals of the economy, the exchange rate that is targeted may be altered. Exchanged rates that are pegged are normally utilized by countries that are considered small. To safeguard a specific rate, the country may be required to resort to the intervention of central bank. However, there are benefits and drawbacks when focusing on pegged exchange rate regime (Mourmouras & Arghyrou 2000). The benefit is having the ability to control domestic currency. In doing so, it will be able to keep its exchange rate to a minimum. This assists the competitiveness of its products as they get sold in countries that are foreign. For instance, let us look at a strong Euro/Vietnamese Dong exchange rate. Since the Euro is superior to the Vietnamese currency, a trouser can cost a company four times more to produce in a European Union country as likened to Vietnam. In ensuring exchange rates a low, a domestic product will have a competitive advantage at home and abroad. There is, however, a drawback when looking at pegged exchange rate regime. Import inflation is one drawback. The difficulty with big currency storage is that the immense amount of money that is being made can lead to undesirable economic side effects, in particular high inflation. The more a country has reserve of currency, the broader the monetary supply resulting in the rise in price. This rise in price can lead to mayhem for countries that are intending on keeping the exchange rate stable. Adoption of a Single Currency The adoption of a single currency like Euro has both benefits and drawbacks in managing exchange rate volatility. The Eurozone is a benefit for European Union members because it brings about low inflation, long-term investment, stable growth and controlling exchange rate volatility. Some of the Eurozone countries have experienced crisis. Greece, for instance, has had long-term fiscal imbalances and joining the Eurozone increased its debt (Mourmouras & Arghyrou 2000). The Eurozone provides a huge economy where markets are bigger and homogenous. In this economy, the risks related to exchange rate vanish and costs are decreased. Additionally, the introduction of the Euro as a common currency has seen an increase in competition in the production of services and goods in the economy. Being in a union with a common currency brings political harmony and economic stability. This stability assists member countries to have a stable currency. However, the uncertainty concerning the exchange rate persists. In a market controlled by exchange rates, unfavourable policies usually lead to losses. The Euro removes exchange rate fluctuation and hence an organization can reduce uncertainty in their investment and export planning. With the benefits of having a single currency like the Euro, exchange rate volatility is controlled because all the countries conduct all their businesses under a single currency. Conclusion With globalization breaking international barriers it makes the exchange rate influence income factors, such as inflation, capital gains and interest rates from domestic securities (Hill 2012). Whereas exchange rates are influenced by many complex factors that usually leave the most experienced economists confused, investors should try to gain an understanding of how value of currency and exchange rates play a crucial role in their investment on rate of return. It is evident in the discussion that exchange rate regimes are important in managing the currency of a country. It could be the central bank controlling exchange rate or it could be a currency being tied to another currency like the United States dollar. With a single currency, it is evident that exchange rate volatility is controlled because all the countries using the same currency transact with one another. Bibliography Hill, C 2012, International Business (9th edition), McGraw Hill, New York City. Hill, C 2007, Global Business Today, McGraw Hill, 4/e, New York City: Mmieh F 2012, International Business Economics: A student’s guide to theory and practice (2nd edition), Pearson Custom Publication, Harlow . Mourmouras, I & Arghyrou, M 2000, Monetary policy at the European periphery, Springer: Berlin. Piggott, J & Cook, M 2006, International Business Economics, MacMillan, Basingstoke: Palgrave. Sloman, J & Hinde, K 2010, Economics for Business (5th edition), FT Prentice and Hall, New Jersey . World Bank 2014, Syria overview, viewed 12 March 2015, . Read More