A
foreign exchange rate is the price of the domestic currency stated in terms of
another currency. For example, one can exchange US dollars for euros. Forex
transactions can be done on the forex market that market, commonly known as the
foreign exchange market.
With
trillions of dollars traded between hands every day. The money market is the
largest and most liquid market in the world. There is no gathering place instead,
the forex market is an electronic network of institutions, banks, brokers, and
individual traders. (Mainly through brokers or banks).
The
market determines the value of most currencies, which is commonly referred to
as an exchange rate. One foreign exchange requirement can be met by merely
exchanging one currency for another at a nearby bank. Currency trading on the
foreign exchange market is an additional choice. For instance, an investor can
stake money on the possibility that a central bank will ease or tighten
monetary policy as well as the strength of one currency vs. another.
Many
factors can potentially influence the market forces behind foreign exchange
rates. The factors include various economic, political, and even psychological
conditions. The economic factors include a government's economic policies,
trade balances, inflation, and economic growth outlook.
Main causes of
fluctuations in exchange rates of international payments
1. Trade Movements
2. Capital Movements
3. Stock Exchange Operations
4. Speculative Transactions
5. Banking Operations
6. Monetary Policy
7. Political Conditions
Important among these
are:
1.
Trade Movements: Any change in
imports or exports will certainly cause a change in the rate of exchange. If
imports exceed exports, the demand for foreign currency rises, hence the rate
of exchange moves against the country. Conversely, if exports exceed imports,
the demand for domestic currency rises and the rate of exchange moves in favor
of the country.
2.
Capital Movements: International
capital movements from one country for short periods to avail of the high rate
of interest prevailing abroad or for long periods for the purpose of making
long-term investment abroad. Any export or import of capital from one country
to another will bring about a change in
3.
Stock Exchange Operations: These
include granting of loans, payment of interest on foreign loans, repatriation
of foreign capital, purchase and sale of foreign securities e c., which
influence demand for foreign funds and through it the exchange rates.
For
instance, when a loan is given by the home country to a foreign nation, the
demand for foreign money increases and the rate of exchange tends to move
unfavorably for the home country. But, when foreigners repay their loan, the
demand for home currency exceeds its supply and the rate of exchange becomes
favorable.
4.
Speculative Transactions: These
include transactions ranging from anticipation of seasonal movements in
exchange rates to the extreme one, viz., flight of capital. In periods of political
uncertainty, there is heavy speculation in foreign money. There is a scramble
for purchasing certain currencies and some currencies are unloaded. Thus,
speculative activities bring about wide fluctuations in exchange rates.
5. Banking Operations: Banks are the
major dealers in foreign exchange. They sell drafts, transfer funds, issue
letters of credit, accept foreign bills of exchange, take up arbitrage, etc.
These operations influence the demand for and supply of foreign exchange, and
hence the exchange rates.
6.
Monetary Policy: An expansionist
monetary policy has generally an inflationary impact, while a constructionist
policy tends to have a deflationary inflation. Inflation and deflation bring
about a change in the internal value of money. This reflects in a similar
change in the external value of money. Inflation means a rise in the domestic
price level, fall in the internal purchasing power of money, and hence a fall
in the exchange rate.
7.
Political Conditions: Political
stability of a country can help very much to maintain a high exchange rate for
its currency: for it attracts foreign capital which causes the foreign exchange
rate to move in its favour. Political instability, on the other hand, causes a
panic flight of capital from the country hence the home currency depreciates in
the eyes of foreigners and consequently, its exchange value falls.
8. Inflation Rates: Changes in market
inflation cause changes in currency exchange rates. A country with a lower
inflation rate than another's will see an appreciation in the value of its
currency. The prices of goods and services increase at a slower rate where the
inflation is low. A country with a consistently lower inflation rate exhibits a
rising currency value while a country with higher inflation typically sees
depreciation in its currency and is usually accompanied by higher interest rates.
In
fact, there are various factors which affect or influence the demand for and
supply of foreign currency (or mutual demand for each other's currencies) which
are ultimately responsible for the short-term fluctuations in the exchange
rate.