What factors affect the exchange rate?

tech 2024-08-25 141 COMMENTS

Professor Fei Jinghan, former chairman of the China Economic Research Institute in Taiwan and a renowned economist, once said that there are three things that drive American young men crazy: first, joining the army; second, lovelorn; third, predicting exchange rates. Professor Fei's statement that "predicting the trend of exchange rates" can drive people crazy shows how difficult this task is. The reasons for the fluctuation of exchange rates are various. In general, the change in a country's economic strength and the choice of macroeconomic policies are the fundamental reasons for determining the long-term development trend of exchange rates. In addition, the following factors also affect the fluctuation of exchange rates:

1. Balance of Payments

The balance of payments is the leading factor in determining the trend of exchange rates. When the income is greater than the expenditure, a surplus occurs, indicating an increased demand for the currency of the surplus country, and the demand for the country's currency exceeds the supply, which will lead to an appreciation of the exchange rate. Conversely, when a deficit occurs, the supply of the country's currency exceeds the demand, and the exchange rate will decrease. It should be noted that short-term capital flows in the capital account have a strong speculative nature and can greatly affect the supply and demand, as well as the rise and fall of the exchange rate.

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2. National Income

The change in national income affects whether the exchange rate will rise or fall, depending on the reason for the change in national income. If the national income increases due to an increase in the supply of goods, then over a longer period, the purchasing power of the country's currency will be strengthened, and the exchange rate will decrease. If the national income increases due to an expansion of government spending or an expansion of total demand, and the supply remains unchanged, the excess demand must be met by expanding imports, which will increase the demand for foreign exchange and lead to an appreciation of the exchange rate.

3. Inflation

Inflation refers to the phenomenon of currency devaluation and price increase caused by the supply of money exceeding the amount of money needed for commodity circulation. When a country experiences inflation, its commodity costs will inevitably increase, and the price of exported goods expressed in foreign currency will inevitably rise, weakening the competitiveness of the goods in the international market. Compared with other countries, if the country's price increase rate exceeds that of other countries, the government will find it difficult to maintain normal exports without adjusting the exchange rate, so inflation will ultimately lead to the devaluation of the currency against foreign currencies, causing fluctuations in the exchange rate.

It should be noted that the inflation rate will also affect the difference between domestic and foreign real interest rates, which in turn affects the capital account of the balance of payments. An excessively high inflation rate will inevitably lead to capital outflow and will also affect the market's expectations for future prices and exchange rates. These manifestations will also have an impact on the fluctuation of the exchange rate.

4. Interest RatesThe differences in interest rate levels among countries can directly affect the flow of short-term capital between nations and have a certain regulatory effect on exchange rate fluctuations. When a country raises its interest rate, it can encourage the inflow of foreign capital, leading to an increased demand for its currency and an appreciation of the exchange rate. Conversely, when interest rates are lowered, it can lead to capital outflows and a potential depreciation of the exchange rate. It is important to note that the difference in interest rates is mainly reflected in the differences in real interest rates among countries. In Western countries, the calculation of real interest rates usually refers to the difference between long-term government bond yields and the inflation rate.

5. Market Expectation Psychology

Market expectation psychology plays a significant role in exchange rate movements. When people are optimistic about a country's economic conditions, balance of payments, inflation, and interest rate prospects, it can lead to a large purchase of that country's currency, causing the exchange rate to rise. On the other hand, if the outlook is pessimistic, the exchange rate will fall. This psychological expectation is accompanied by various speculative factors, and even rumors or speeches by certain leaders can trigger speculative activities, potentially causing significant fluctuations in the foreign exchange market and leading to large ups and downs in exchange rates.

6. Macroeconomic Policies of Countries

The macroeconomic policies of countries, especially fiscal and financial policies, have a considerable impact on exchange rates. For example, when a country implements a "tight" fiscal and financial policy, its currency's external exchange rate generally tends to rise. When a country implements a "loose" fiscal and financial policy, it can lead to a depreciation of the currency's exchange rate.

7. Intervention by Monetary Authorities

Central banks in Western countries often intervene in the market to maintain economic stability and prevent adverse effects on the domestic economy due to exchange rate fluctuations. They do this by buying and selling foreign exchange to influence exchange rates in a way that benefits their own economy.

8. Sudden Factors

Political and sudden factors have a direct and rapid impact on the foreign exchange market. These factors include the stability and continuity of the political situation, the government's foreign policy, as well as wars, economic sanctions, and natural disasters. Additionally, elections in Western countries can also affect the foreign exchange market. Due to their sudden and temporary nature, political and sudden events are difficult for the market to predict, making them prone to causing shocks in the market.In summary, the factors that influence exchange rates are diverse and their relationships are intricate and complex. Sometimes these factors act simultaneously, sometimes individual factors take effect, and at times these factors may even counteract each other. However, in the long run, the fluctuation of exchange rates is primarily constrained by the balance of international payments and inflation, thus the state of international payments and inflation are the fundamental factors that determine the changes in exchange rates. Interest rate factors and exchange rate policies can only play a subordinate role.

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