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Some Basic Relationship
Suppose that individuals were not
worried about risk and that there wereno barrier or costs to international trade.
In this situation spot exchange rates,
forward exchange, interest rates and
inflation rates would stand in followingsimple relationship to one another.
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Changes in the exchange rates and inflationrates:
Let us understand now the relationship between exchange rateand inflation. Suppose you notice that silver can be bought in
New York for $4.80 per unit and sold in Zurich for sfr7. then youexchange your sfr for 7, @ $/1.3125 = $ 5.33 You make gross profitof $.53 per unit: Such situations does not exist-not long as othersnotice the disparity between the price of silver in Zurich andprice in New York, price will be forced down in Zurich and up
in New York until the profits opportunity disappear. Arbitrageensures that dollar price of silver is about the same in the twocountries. Of course silver is a standard and easily transportablecommodity but to some degree you might expect that same
forces would be acting to equalize the domestic and foreignprices of other goods.
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Those goods that can be bought more cheaply abroadwould be imported and that will force down the priceof domestic product. Similarly those goods that can be
bought more cheaply in USA will be exported and thatwill force down the price of foreign product. This isoften called the law of one price or in more generalsense purchasing power parity theory. Law of one
price implies that any differences in the rates ofinflation will be offset by I change in exchange rate.
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FAC
TORS A
FFECT
INGEX
CHANGE
RATE
S.
In floating rate the exchange rates fluctuate because of changein demand and supply of currency.
Principal factors affecting exchange rate are1. Short term factors.
a. Commercial factors.
b. Financial factors.
2. Long term factorsa. Currency and economic conditions.b. Political and industrial conditions.
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Case of Short Term Time Horizon
1) Country's current account balance is better indicator ofexchange rate trends. Surplus i.e. foreign exchange netinflows from export earnings pushes country's currency valuehigher as has happened in recent times with regard to rupee
vs. dollar. A nation·s international competitiveness and withit the trend of its current account depends on differentfactors. Inflation will diminish export after a certain futureperiod and increase imports.
2) High economic growth of a country strengthens the homecurrency.
3) Foreign currency inflows from trade and services (banking,
shipping, tourism and so on) strengthens dometic currency.
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4) Loan and interest rate receipts and payments in foreign
currency by private and public sector influences the demand
and supply of foreign currency and resultantly its value.
5) Salaries and profits of foreign companies and their
remittances also influence the demand and supply of foreign
currency and its value.
6)Capital movements also dominate exchange rate
developments over weeks/months.
Technical factors: For short period technical factors can
sometimes have influence on exchange rates. Regulations by
Central Bank about size of open positions, make it necessary
to reduce or cover short positions at any given moment and it
create a technical but genuine demand for currency.
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Long term actors:
1. Economic factors are of decisive importance. These can be ranging from GDP growth rate, industry growth, agricultural growth,
inflation, interest rates and so on.
2. Non economic factors: Political or psychological factors can alsohave a bearing on exchange rate behaviour, inflation, interest ratesand so on.
3. Market participants not only act on the basis known facts andfigures but they also base them selves on expectations. This factoradds to volatility of foreign exchange market.
4. Speculative activities by private sector.
5. Industrial conditions: Current position and future outlook in theindustrial field are also important influences in the exchangemarket.
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Existence of industry peace, stable level of wages,
prices, high level of efficiency of productioncontribute to strengthening effect on the exchangevalue of currency in the long period. Converselyindustrial unrest, unduly high cost of production,
inefficient production, have an adverse effect on theexchange value of currency.
