How Currency and Foreign Exchange Rates are Determined?
Determining currency price is not much different from determining fruit/ vegetable prices, the basic phenomenon and factor of price determination in currency movement and fruits/ vegetables is market forces of demand and supply.
An increase in demand of dollar will result in an increase in dollar’s value. The price of one dollar is quoted such as how much rupees are required to buy one dollar, therefore an increase in dollar value automatically means the decrease in Rupees value and vice-versa.
Some market forces control and even manipulate the demand and supply of currency.
Unstable markets make investors take precautionary moves and they prefer parking their money in safe havens such as gold, US treasuries, Swiss franc, all this is done to avoid losses to their portfolios. This act could also lead foreign investors to start pulling out their investments.
There are over-the-counter and derivative instruments through which one can speculate the underlying currency rates. When speculators sense some movement in the market, they also want to take benefit from rising/ falling value of dollar. The buying and selling of dollar starts affecting the demand and supply of the dollar.
Central Bank (RBI) Intervention:
RBI is responsible for keeping balance between rupee’s appreciation and depreciation. When there is too much volatility in rupee-dollar rates, in order to protect the local economy, RBI buys or sells dollar to control the rates.
Imports and Exports:
One should buy Pakistani products to strengthen Pakistani rupees, since importing goods requires paying taxes and that too in dollars that can weaken rupee. However, exports have a lot of schemes and incentives and our economy is being protected by keeping conditions and taxes on imports and giving special incentives to exporters.
Public Debt / Fiscal policy:
When government exceeds its expenses from revenues, a shortage of funds generates and to overcome it money is being borrowed from World Bank and the IMF. These high debts, interest rates and payments also result in currency fluctuations.
The increasing interest rates have caused inflation to increase as well. If the foreign investors become comfortable with the credit ratings, it will attract a lot of money to Pakistan and thus a supply of dollars.
In a floating exchange rate system, currency exchange rates are determined with respect to other currency. Currency depreciation is the loss of value of a country’s currency with reference to the one or more foreign currencies. It is used for the increase of exchange rate due to market forces, sometimes it is also appears as devaluation. The exact opposite, an increase in value of a currency is called currency appreciation.
The depreciation of a country’s currency refers to a decrease in the value of that country’s currency. For instance, if the Canadian dollar depreciates relative to the euro, the exchange rate (the Canadian dollar price of euros) rises: it takes more Canadian dollars to purchase 1 euro.
When the Canadian dollar depreciates relative to the euro, Canadian goods become more competitive on world markets because their price when exchanged to euro will be lower. The result will be an increase in Canadian exports. On the other hand, European sellers that denominate their goods and services in euros will be less competitive, because European products denominated in euros will be more expensive in Canada.
The appreciation of a country’s currency refers to an increase in the value of that country’s currency. Continuing with the CAD/EUR example, if the Canadian dollar appreciates relative to the euro, the exchange rate falls: it takes fewer Canadian dollars to purchase 1 euro. When the Canadian dollar appreciates relative to the Euro, the Canadian dollar becomes less competitive. This will lead to larger imports of European goods and services, and lower exports of Canadian goods and services.
How are foreign exchange rates set?
One unit of a currency exchanged for another currency is the international currency exchange rate. Currency exchange rates can fluctuate continuously depending on different factors, or they can also be fixed with another currency, the value would still fluctuate but with regards to the currency they are fixed with.
If you know the value of your home currency in relation to different currencies then it is easier for investors to analyse their investments in dollars. Decline in the value of US dollar could result in increased value of foreign investments and vice versa.
Factors That Influence Exchange Rates
Supply and demand of a currency determines the rates and their fluctuation. The demand of a currency in relation to the supply will define the currency’s value in relation to the other currency. For example, the demand of U.S dollars by Pakistan increases, this will cause an increase in the price of UD dollars in relation to the Pakistani rupee. A few most important factors impacting the International exchange rates are: interest rate decisions, unemployment rates, inflation reports, gross domestic product numbers and manufacturing information.
Some countries use fixed exchange rates by the government that do not fluctuate and are reset on revaluation dates. This is often done by the emerging and establishing markets countries to protect their economies and maintain stability in the values of currency. To maintain the stability of their currency governments should have large reserves of foreign currency with respect to the fixed currency to keep supply and demand under control.