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An exchange rate is a rate at which one currency will be exchanged for another. It affects trade and the movement of money between countries. Exchange rates are impacted by both the domestic currency value and the foreign currency value. The exchange rate between two currencies is commonly determined by the economic activity, market interest rates, gross domestic product, and unemployment rate in each country.
It also plays a vital role in a country’s level of trade, which is critical to almost every free market economy in the world. A higher-valued currency makes a country’s imports less expensive and its exports more expensive in foreign markets. While a lower-valued currency makes a country’s imports more expensive and its exports less expensive in foreign markets. Also, a higher exchange rate can be expected to worsen a country’s balance of trade, while a lower exchange rate can be expected to improve it.
Numerous factors determine exchange rate movement. Many of these factors are related to the trading relationship between the two countries. Remember, exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries.
Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country’s exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country’s exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country’s currency (and an increase in the currency’s value). If the price of exports rises by a smaller rate than that of its imports, the currency’s value will decrease in relation to its trading partners.
Differentials in Interest Rates
Interest rates, inflation, and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates – that is, lower interest rates tend to decrease exchange rates.
Differentials in Inflation
Typically, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the 20th century, the countries with low inflation included Japan, Germany, and Switzerland, while the U.S.and Canada achieved low inflation only later.
Those countries with higher inflation typically see depreciation in their currency to the currencies of their trading partners. This is also usually accompanied by higher interest rates.
While most exchange rates are floating and will rise or fall based on the supply and demand in the market, some exchange rates are pegged or fixed to the value of a specific country’s currency. Exchange rate changes affect businesses and the cost of supplies and demand for their products in the international marketplace.
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