Exchange rate is the value of a national currency against other currencies. It is the rate at which one national currency will be exchanged for another. There are two forms of currency exchange rates: floating and fixed. Floating exchange rates change constantly and are determined by forces of supply and demand, while fixed exchange rates obstruct currency movements within a narrow range set by the central bank. Exchange rates are relative and used as a comparison of the currencies of two countries.
Currency Appreciation: It is the increase in one currency’s value against another. Currency appreciation usually reflects economic growth, higher interest rate, and increase of demand.
Currency Depreciation: It’s when a currency falls in value against its rivals. It occurs due to weak economic performance, political instability, interest rate differentials, or risk aversion during uncertain times.
What affects Exchange Rate?
Exchange rate has a direct effect on overall economic activity, trade and sentiment. That’s why exchange rates are always watched, analyzed and manipulated directly in order to maintain economic stability. Higher exchange rates mean less expensive imports and more expensive exports which lowers competitiveness of national goods, and could lead to negative trade balance gapping. On the other hand, lower exchange rates support exports and trade activity.
1. Inflation Rate:
It is one major factor affecting exchange rates. Typically, lower inflation rate leads to a rising currency value, as its purchasing power increases relative to other currencies. The prices of goods and services increase slowly when the inflation is low. While with high inflation, we see depreciation in currency value even if it is accompanied by higher interest rates.
2. Interest Rates:
Changes in interest rates directly affect currency value and its exchange rate against other currencies. Higher interest rates offer lenders a higher return compared to other countries which attracts more foreign capital, causing a rise in exchange rates. It’s worth noting that interest rates, inflation and exchange rates are all correlated. Central banks use interest rates to control both inflation and exchange rates.
3. Terms of Trade:
Terms of trade are defined as the ratio between export and import prices. If the export prices increase more than the import prices, then terms of trade are good. The increase in terms of trade indicates greater demand for a country’s exports. Accordingly, it will result in an increase in revenue from exports which results in raising demand for the national currency, thus increasing its value. In case of rising the price of exports by a lower rate than its imports, the currency’s value will depreciate compared to currencies of its trading partners.
4. Public Debt:
Public debt or government debt or national debt is the total debt owned by the central government. While governmental spending stimulates the domestic economy, national large public deficits hold back investing competitiveness. Countries with large public debts are less attractive to foreign investors and less likely to obtain foreign capital, which fuels inflation. When foreign investors forecast a rise in government debt of a particular country, they prefer not to own securities denominated in its currency, especially if the risk of default is great. So, the country’s debt rating is a very crucial factor in setting exchange rates.