Determination Of Exchange Rates | Kotak Securities (2024)

Key Highlights

• Factors like inflation, speculation, interest rates, competitiveness, and government debt affect exchange rates.

• There are different levels of government intervention in fixed, pegged floating, and floating exchange rate systems.

• Lower inflation rates can boost the demand for a nation's currency and increase the competitiveness of its exports.

• As investors look for higher returns, disparities in interest rates among nations have an impact on currency rates.

Exchange Rate Determination

The exchange rate of currencies may be determined using a variety of techniques. Popular techniques include:

Floating Exchange Rate

A flexible exchange rate can change over time. The variable exchange rate fluctuates between several values. The market decides whether or not the exchange rate changes. Any currency that is subject to a floating regime is referred to as a "floating currency."

One illustration of a floating exchange currency is the US dollar.

It is noteworthy that floating rates are well-liked among economists. Free market advocates hold the view that the market should decide the value of currencies. When crude oil prices increase, for instance, the USD values often fall. Therefore, the value of the USD and the price of crude oil are inversely connected. As a result, the USD value varies freely due to daily changes in oil prices.

According to economists, markets often correct themselves regularly. Because of minimal government interference, the majority of large economies are often dependent on floating exchanges. 'First World Countries' is the term used to describe these nations.

Pegged Floating Exchange RatesIn this system, there are three hybrid domains. By interfering in the markets, governments and central banks can regulate foreign currency rates.

Crawling BandsA central bank will permit currency movements up to a particular range that is often predetermined in advance. Once the range is crossed, the authorities will step in. The monetary and economic policies establish these ranges.

Crawling PegsBecause of the arrangement, the Central Bank permits a steady increase or decrease in the value of its currency on global markets. If there are any market turbulences, the currency will be able to float. However, if one appreciation or depreciation is quickly followed by another, the authorities will step in. Argentina, Vietnam, and Costa Rica have previously experienced this.

Horizontally Pegged BandsIt almost resembles crawling bands. Nevertheless, Central Banks permit significantly greater currency fluctuations as long as the exchange rate doesn't go over 1% of the currency's gross value.

Flexible Exchange Rate

The flexible exchange rate is also known as a pegged exchange rate regime because of government interference. A currency is kept at par with other currencies, either individually or collectively, or with the gold and foreign currency reserves held by the nation in question.

Fixed Exchange Rate

The most well-known example of fixed exchange regimes is arguably China. Under the previous Soviet Union, there also used to be a fixed-rate system. It should be remembered that market forces are not the only factors influencing the flexible exchange rate. The central banks will need to sell or purchase currency reserves if the foreign exchange market moves significantly.

For instance, the government could decide to "fix" the exchange rate at Rs. 75, while the actual economic and foreign exchange market conditions might only allow for Rs. 70.

In this scenario, there will be a greater supply of foreign exchange available for the conversion of dollars to rupees than there will be a demand from Indians for dollars to be converted from rupees to dollars. This is due to the fact that the dollar is only worth Rs. 70 in reality. However, it will get Rs. 75. More people will convert dollars to rupees as a result, increasing the supply of dollars relative to demand. This is an instance of excess supply, or when there is more foreign currency available than there is demand.

Factors Affecting Exchange Rates

The following are the key factors that affect the exchange rate of currencies.

1. InflationThe UK's exports will become more competitive, and there will be a rise in the demand for Pound Sterling to purchase UK goods if inflation there is substantially lower than elsewhere. Additionally, foreign items will be less affordable, leading UK residents to purchase fewer imports.

As a result, the value of a currency tends to increase in nations with lower inflation rates. For instance, the comparatively lower inflation rate in the post-war era was associated with the long-term appreciation of the German D-Mark.

2. SpeculationEvery country has access to money. As a result, residents of one nation may own foreign currency reserves from another nation. Therefore, if Indians believe that the value of their currency may vary soon, they will be more interested in the value of the USD. Currency values are impacted when people hoard foreign exchange in order to profit from shifting values.

3. Interest RatesThe value of exchange rates is significantly influenced by the variance in interest rates between nations. Banks, multinational corporations, and wealthy investors spend money all across the world to increase profits. This has a significant impact on a country's exchange rates as well.

4. Change In CompetitivenessThe value of the exchange rate will increase as British goods become more appealing and competitive. For instance, if the UK sees long-term improvements in labour market relations and improved productivity, the country will become more globally competitive over time, which would eventually lead to the pound strengthening. This element is comparable to low inflation.

5. Balance Of PaymentsWhen the value of imports (of goods and services) exceeds the value of exports, there is a current account deficit. This is acceptable if it is financed by a financial/capital account surplus. However, currency depreciation will occur in a nation that finds it difficult to draw sufficient capital inflows to sustain a current account deficit.

6. Government DebtThe value of government debt may occasionally have an impact on the exchange rate. Investors will sell their bonds if markets believe a government will be unable to pay its debt, which would lower the value of the exchange rate. For instance, Iceland's 2008 debt issues led to a sharp decline in the value of the Icelandic currency.

Exchange Rates In The Long Run

In a flexible exchange rate framework, long-term predictions about the exchange rates are made using the notion of PPP or purchasing power parity. According to the theory, exchange rates must gradually adjust so that the same products cost the same prices regardless of whether they are quantified in rupees in India, yen in Japan, or dollars in the US, with the exception of the differences in transportation. This is because there are no business frontiers like taxes (tariffs on business) and quotas (quantitative constraints on imports).

Therefore, the value of the money must be the same in terms of exchange rates. It doesn't matter whether it is being transferred into rupees in India, yen in Japan, or dollars in the US.

Conclusion

Determination of the exchange rate is crucial. Everyone is impacted by changes in currency rates since it is the engine that drives an economy. Governments, therefore, work to raise the value of their national currencies to manage the balance of payments in a satisfactory manner. The net difference between a country's total imports and exports is known as its balance of payments. Therefore, when exchange rates are high, a smaller amount of cash may bring you more goods on global marketplaces. This enhances the value that nations provide to their residents by assisting them in managing a healthy rate of economic growth.