Long-run Determinants of Exchange Rates - Essay Example

TERMS OF REFERENCE This paper attempts to evaluate and analyse the various factors that determine exchange rates in the long run. This paper aims toidentify and evaluate the long-run determinants of exchange rates with the help of available literature. Methodology The various determinants of exchange rates and factors causing fluctuations in currency rates have been evaluated with the help of secondary data sources. For this purpose, a range of data was utilised from books, journal articles and the Internet resources. The paper presents an insightful study on the impact of various factors on exchange rates such as monetary policy, inflation, imports and exports, government spending, economic productivity and foreign reserve etc by utilising the research and studies conducted by different scholars [(Krueger, 1983), (Rodriguez, 1977), (Diulio, 1998), (Stockman, 1980) etc]. INTRODUCTION There are several factors that are responsible in determining exchange rate in any country. Exchange rates show the value of a country's currency through which it can buy other country's currencies. Every country needs stable foreign exchange rate to trade freely. Exchange rate may get affected through various things. There are two regimes with respect to exchange rate which can either be fixed or flexible. In fixed exchange rate regimes, the currency rates do not move freely. However, in flexible exchange rate system, the currency rates are affected by a number of variables prevailing in an economy. The macroeconomic factors that affect exchange rates are variable by nature and thus play a great role in determining exchange rates. Governments and Central Banks especially utilize these macroeconomic factors to maintain a desired level of exchange rate in the economy. These macroeconomic factors may lead to great fluctuations in exchange rates both in short and long run. The factors that determine exchange rate in the long run include imports/exports, monetary shocks, inflation, demand/supply pressures, foreign reserves, economic productivity and government spending etc. The study of factors determining exchange rate in the long run is important so as to understand the reasons for which the currency rates appreciate or depreciate. This paper shed light on the factors determining exchange rates in the long run and evaluates these exchange rate determinants. It elaborates and gives comprehensive understanding of factors that can cause the value of a currency to fluctuate. DETERMINANTS OF EXCHANGE RATE IN LONG RUN Exchange rates greatly signify a country's overall economic position and trading prospects. These rates depict a country's position in terms of its currency's price with respect to that of the other. These are mainly the rates at which currencies could be bought and sold. Exchanges rates have a great impact on other economic variables of a country such as money supply, trade growth, imports, exports and interest rates etc. In the same vein, there are several factors that cause fluctuations in a currency's exchange rates. These determinants of foreign exchange rates may be external or internal and tend to play a great role in causing changes to currency rates. Some of these factors either take place in the short run while several cause exchange rate fluctuations in the long run. The rest of the paper elaborates and evaluates the various determinants of currency exchange rate in the long run. Exports and Imports Countries having fewer imports and more exports usually have high exchange rates. In the same fashion, countries having a lower tendency to export and have imports tend to have trade deficits. Current account surplus and deficit play a significant role in determining exchange rate of a particular country. The elements form crucial elements of a country's GDP. Balance of payment in the receipt side shows the trade surplus and thus puts the positive impacts on exchange rate while the balance of payment in the payment side reflects the trade deficit or loss which puts the negative impact on exchange rate. Krueger also propounds that "countries in current account surplus tended to have appreciating exchange rates, whereas those in current-account deficit more often experienced depreciating exchange rates" (1983, p. 102) It is because when there is current account deficit in a country, there is a need for foreign inflows of capital in the form of borrowing. For this purpose, the currency rate has to fall down in order to attract foreign investors to buy the currency and vice versa. Imports and Exports also affect exchange rates by effecting demand and supply mechanisms. The more the demand for foreign goods and services increases in an economy i.e. the demand for imported goods, the more the exchange rate of that economy falls down. Stockman suggests, "since imports must be financed with foreign exchange (foreign money) [it] results in a demand for foreign exchange that is derived from the demand for imports" (1980, p. 681). As a matter of fact, as the demand for imported goods in a country rises, the demand for foreign exchange increases because the price of imports is generally paid in seller's currency. In this way, the rate of foreign currency will rise and the country will have to pay more units of currency to purchase the quantity of goods and services. Hence, the level of imports and exports in a country causes great fluctuations to the exchange rates. Foreign Reserve Another factor that determines the exchange rate is the foreign exchange reserve. Countries having sufficient amount of foreign exchange reserve would have lower rates of exchange. Rodriguez asserts that " the higher the existing stock of foreign exchange, the lower will be the foreign exchange rate" (1977, p622). The current amount of foreign exchange in any country is one of the factors influencing exchange rate. The availability of foreign reserves can push up and pull down the exchange rates. It is because of the fact that countries with high accumulation of foreign currencies will have to pay more units of its currency to buy foreign exchange causing its local currency to fall down. Most developing countries in the world opt for high reserves in order to keep their currencies down so as to boost exports and enhance revenues. China happens to be a great example in this regard which devalues its currency to bolster its economic growth with the help of exports. Monetary Policy Monetary expansion also has its significant role in fixing the exchange rate. The monetary shocks or monetary policies may lead to wide change in exchange rate (Stockman, 1980). One of the factors that determine the exchange rate happens to be monetary shocks. The prices of various products in different countries are not the same. Every country has its own rates on that it may trade which are usually fixed in every country. A sudden change in money supply may also lead to great changes in the exchange rate in the long run. Change in the interest rate of a country puts its impact in determining the exchange rate. The change in interest rate would either increase or decrease foreign investment in a country. The ultimate rise in interest rate helps a country to increase its foreign exchange. With the changes in monetary policy or monetary expansion, the exchange rate would also fluctuate. If the monetary expansion gets wider or the supply of money increases in an economy, the result would appear in the shape of sudden decrease in currency exchange rate. The expansion in monetary policy raises not only the exchange rate but also increases the prices to an extent (Rodriguez, 1977). The effects of monetary expansion on exchange rate are undisputable. The exchange rates do increase or decrease when any changes take place in monetary policy. The changes that occur in the monetary policies do have an impact on determination of exchange rate by means of affecting the supply of money in an economy. It is because expansionary monetary policy reduces the value of local currency deposits as compared to foreign currency deposits causing the local currency to depreciate in value. The fact that monetary policy impact on exchange rate is short run or long run depends on the nature of shift in monetary policy. If the monetary is imposed permanently in an economy, the exchange rate change would be long run whereas if monetary policy is set temporarily, the exchange rate will revert back to its actual position in short run. Demand and Supply Mechanisms Countries tend to sell and purchase currencies to maintain its exchange rate. As and when demand and supply of currencies get affected the exchange rate tend to increase or decrease. If the demand for the currency is higher, its exchange rate tends to increase. Foreign exchange is needed in order to buy goods and services from abroad. Counties that have outstanding market of foreign buyers have higher exchange rate. Diulio also says that " the exchange rate changes in response to a change in the supply and/or demand foreign and the domestic currency." (1998, p148) This is the reason explaining why the USA has a higher exchange rate. Changes may occur in exchange rate due to the shift of demand and supply of the currency. The demand and supply mechanisms are important determinants of foreign exchange rates. These mechanisms are also used by countries to maintain a desired level of exchange rate in the economy. Fluctuations may also occur due the external forces affecting demand and supply of the currency. We can say that with the increase in the interest rate of a country like USA, the local and foreign investment would also rise in the country rather than other countries like Germany. Investors would not prefer to invest in Germany as they could see attractive interest rates and growth prospect in USA. That would not only increase the investment in the U.S. but also to an extent lead to appreciation of exchange rate of the United States. The same is the case with Germany; if its interest rate rises the investment may shift towards Germany from the U.S. As Germany becomes more profitable country for investment the demand for dollar would also decrease and the value of Deutsche Mark would rise (Diulio, 1998). The changing demand for foreign exchange due to demand and supply shocks put significant impact on exchange rate. Therefore, it can be said that exchange rate may change with the modification in the terms of trade (Stockman, 1980). An increase in the demand for the product of a country, for instance Japan, would also increase the demand for its currency i.e. Yen. The demand for foreign exchange increases with the increase in the demand of particular products. The demand and supply also have its role in determining the exchange rate as it may increase with the time. The amount of the imported product is paid in the currency the respective country's currency i.e. Yen. This increases the demand for Yen and hence causes fluctuation in the exchange rate. Inflation Rate Rate of inflation is a pre-eminent determinant of any country's exchange rate. The Purchasing Power Parity (PPP) shows the equal relationship between ratio of foreign and local price index in a country with the exchange rate (Stockman, 1980). Inflation in any country increases the prices of local manufactured products. Consequently, it causes fluctuations in the exchange rate. There is a great relationship between purchasing price parity (PPP) and the exchange rate of particular country. Stockman defines that according to the Purchasing Power Parity, " there is a proportional relationship between the exchange rate and a ratio of foreign and domestic prices or price indexes" (1980, p 675) Prices of goods and services may differ from one country to another country, as the nominal domestic prices remain temporary fixed in every country. Inflation also has particularly a long run impact on exchange rate. Exchange rate may decrease due to consistent increases in rate of inflation. It affects exchange rate by means of fluctuations in prices in a particular country. If the prices of a commodity tend to increase or decrease it puts its definite impact on trade (Bollard, 2003). The role of inflation cannot be ruled out in determining the exchange rate position. If the rate of inflation increases consistently the exchange rate may decrease. Inflation affects balance of trade as it weakens the economy and so the exchange rate diminishes. Inflation puts negative impact on economy so the exchange rate in that particular economy would also decrease. Inflation should be controlled in order to have positive impact on exchange rate. Exchange rate fluctuates with the changes in the rate of inflation in the economy. Economic Productivity Performance Another determinant that can cause exchange rates to fluctuate is the productivity performance of an economy. High level of output produced in an economy would raise the country's exchange rate. With the continuous increase in inflation the exchange rate would also fall down. Inflation and productivity performance both has the significant role in determining exchange rate for long run (Bollard, 2003). Utilization of inputs to get the maximum output is called the productivity performance of a country. It refers to the overall growth of output in the economy relative to firms and the level of labour productivity. As the economic performance in terms of productivity rises in any country relative to other countries, its exchange rate rises. A country can move its financial capital from one place to another. There is no duty that needs to be paid in this trade. A country can also determine its long run exchange rate through the productivity its labour and capital is showing i.e. the efficiency of labour and capital in producing manufactured goods compared to services. It can be determined by whether labour and capital efficiency in producing manufactured goods is higher or lower than the services they produce as compared to other countries. Higher efficiency in productivity improves the particular country's currency (FRBSF Economic Letter, 1998). A country may also determine its exchange rate by gauging the performance of its labour and capital which means to what extent they are able to provide effective results. These two factors of production if they are efficient enough can put a positive impact over the exchange rate. The manufactured goods (tradable goods) should be giving more performance than non-tradable good (services) compared to other countries. The country's own labour and capital needs be effective and efficient to get the desired positive impact on exchange rate. Oil Dependency and Government Spending Other factors that may lead to changes in exchange rate in the long run include a country's oil dependency and government spending. These factors may enhance or reduce the value of a country's currency to a considerable extent. The countries which are highly oil dependent come directly under influence of changes in oil prices. The countries like Indonesia that is the one of the oil exporting countries of the world exports its oil to other parts of the countries. Its currency (rupiah) gets the appreciation of 0.4% every year due to increase of permanent 1% in real oil prices. On the other hand there are countries like Korea that imports oil from other countries and confronts with the currency depreciation every year (FRBSF Economic Letter, 1998). There are number of reasons they may help in determining the exchange rate. The countries that dependable to other countries in any manner or for any product like oil etc would have to face the currency depreciation, as they do not have availability of such goods. The prices of these good also fluctuate in routine basis and mostly tend to increase. The countries dependable on other countries for the products have to pay heavy sum of foreign exchange to buy it. On the other hand the countries rich in these products earn foreign exchange. With the increase in the prices they tend to earn and due to it their exchange rate also increases. The rate of government spending is also one of the factors that determine the exchange rate. Whatever the rate of government spending, it puts positive impact on the currency of a particular country. Governments usually spend on their local goods so as to establish price pressure which in return causes appreciation in the rate of local currency and reduces the level of demand (FRBSF Economic Letter, 1998). The government that spends a reasonable amount on its local products tends to increase the value of its currency. CONCLUSION This paper elaborates the factors that act as determinants of exchange rate in an economy. Exchange rate is determined by the demand and supply of the currency. These demand and supply mechanisms may affect exchange rates in short and long run. If the product and services of a country is able to attract buyers from all over the world, the importers will purchase the products and services by paying foreign exchange that raises exporting country's domestic exchange rate. Countries that are dependent to other countries for the supply of any product like oil etc have to pay foreign exchange to the exporting countries which would appreciate their foreign exchange rate. Monetary policy has also its impact over the exchange rate. There is an inverse relationship between monetary expansion and exchange rate. When monetary expansion becomes higher the exchange rate starts falling down. An important tool of monetary policy is interest rates. Countries need to maintain their interest rate in order to maintain the stability of exchange rate. Increase in interest rate has the impact over exchange rate. The investor may turn to countries that offer high interest rate on foreign currency assets. Countries that do not have an attractive interest rate as compared to those other countries may loose their investment potential and as a result their exchange rate would also decrease. With the changes in the rate of inflation the exchange rate also fluctuates. The purchasing price theory also reflects a deep relationship between prices and exchange rate. The continuous price changes of domestic product affects the exchange rate to an extent. Government spending and productivity performance are also the main exchange rate determinants. It is up to the government that how it utilizes its available resources to get the maximum output. Effective utilization of funds and better output appreciate the currency value. Hence there happen to be several factors prevailing in the economy that affect the value of a country's currency in terms of others apart from the demand and supply pressures. These factors are utilised as tools for effective exchange rate control on the part of governments and central banks. Reference List Bluedorn, J.C. and Bowdler, C. (2005). 'Monetary Policy and Exchange Rate Dynamics: New Evidence from the Narrative Approach to Shock Identification.' Economics Papers 2005-W18, Economics Group, Nuffield College, University of Oxford Bollard, A. (2003). 'Making Sense of a Rising Exchange Rate.' Reserve Bank of New Zealand. Retrieved 15 May 2007 from the World Wide Web http://www.rbnz.govt.nz/speeches/0129542.html Calvo, G.A. and Rodriguez, C.A. "A model of exchange rate determination under current substitution and rational expectation." The Journal of Political Economy. 85(3), pp. pp. 577-586 Diulio, E.A. (1998). 'Schaum's Outline of Theory and Problems of Macroeconomics.' McGraw-Hill Professional FRBSF Economic Letter (1998). 'Long-run Determinants of East Asian Real Exchange Rates. Federal Reserve Bank of San Francisco, available at: http://www.frbsf.org/econrsrch/wklyltr/wklyltr98/el98-11.html Krueger, A.O. (1983). 'Exchange-Rate Determination.' Cambridge University Press, Cambridge, UK Stockman, A.C. (1980)"A Theory of Exchange Rate Determination" The Journal of Political Economy, 88(4), pp. 673-698 Read More