Exchange rates are influenced by wide ranging economic factors which differ in importance attached to them from one country to another over time. The exchange values for various currencies fluctuate on daily basis or even more frequently according to Smith (2009). Money like any other commodity in the market is largely affected by the forces of demand and supply. International trade largely influences a country’s exchange rate as Mankiw (2007) observes. When a country exports, its national currency’s demand increases causing a rise in its exchange rate relatively to the importer’s currency. This is because the importing country experiences a depreciation of its currency as a result of an increased supply of its currency in the international market which causes a depreciation of its price.
On the other hand, if a country’s goods and services are relatively more expensive to its imports, the demands for imports increase. Its citizens will increasingly import goods from the other country hence leading to depreciation of its currency value. A country’s return to investment can also affect its exchange rate. If for example returns to investment are better in country B, the citizens of country A will increasingly inject more and more of their capital in country B leading an increase in demand for the country B’s currency which then boosts the exchange value of country B’s currency. A higher interest rate will result to better returns from bonds and other government securities and this will definitely attract heavy capital inflow from international investors. The effect is an increase in the country’s currency strength.
The Country’s rate of inflation will also influence the direction of a country’s exchange rate. A higher rate of inflation acts as a disincentive to investors who find the currency unattractive and hence shun it. Speculation about a country’s economic performance also influences its rate of exchange. When a country’s economy is perceived to indicate robust growth, there is increase in investor appetite followed by capital inflow which in turn causes the country’s currency to appreciate in value as a result of increased demand.
Reference
Mankiw NG (2007) 4th edition, Principals of Economics Chapters 4, 5, 6. Web.
Smith E. (2009) What Influences Exchange Rates? Web.