How does exchange rate determined

Budget Deficit: Another major factor which influences the Forex rates is the budget deficit. This is because a budget deficit is a precursor to public debt. Governments spend more money than they have and as a result run up a budget deficit.

This deficit then has to be financed by debt. The problems pertaining to public debt and how it impacts the Forex rate have already been discussed in the above point. Political stability of the country in question is also of prime importance for Forex rates. This is because modern monetary system is a system of Fiat money. This means that money is nothing except the promise of the government.

Therefore, if there is a danger to the government, there is a danger that the promise itself may be worthless once a new government takes over. It is possible that the new government may want to issue a new currency of its own! Therefore, whenever a country faces a geopolitical turmoil, its currency usually takes a beating in the Forex markets.

Lastly, the Forex market is extremely speculative in nature. This is because Forex provides the leverage for investors to amplify their trade several times using borrowed money and then invest in the markets. Therefore, sentiments take over the Forex market more than they take over other asset markets because of the availability of easy money.

Hence, just like all other markets, Forex markets are prone to irrational exuberance and they too can distort exchange rates in the short term creating long term investment opportunities. Many other factors like the price of commodities such as gold and oil also play a vital role in the determination of Forex rates. However, that will be discussed in a later article in this module. How Are Exchange Rates Determined? These assets are not limited to consumables, such as groceries or cars.

They include investments, such as shares of stock that is denominated in the currency, and debt denominated in the currency. Currency is complicated and its value can be measured in several different ways. For example, a currency can be measured in terms of other currencies, or it can be measured in terms of the goods and services it can buy.

An exchange rate between two currencies is defined as the rate at which one currency will be exchanged for another. However, that rate can be interpreted through different perspectives. Below are descriptions of the two most common means of describing exchange rates.

A nominal value is an economic value expressed in monetary terms that is, in units of a currency. It is not influenced by the change of price or value of the goods and services that currencies can buy. Therefore, changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services that the currency is used to buy.

When you go online to find the current exchange rate of a currency, it is generally expressed in nominal terms. The nominal rate is set on the open market and is based on how much of one currency another currency can buy. The real exchange rate is the purchasing power of a currency relative to another at current exchange rates and prices.

The real exchange rate is the nominal rate adjusted for differences in price levels. Using the PPP rate for hypothetical currency conversions, a given amount of one currency has the same purchasing power whether used directly to purchase a market basket of goods or used to convert at the PPP rate to the other currency and then purchase the market basket using that currency. Groceries : Purchasing Power Parity evaluates and compares the prices of goods in different countries, such as groceries.

PPP is then used to help determine real exchange rates. If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity PPP would hold for the exchange rate and price levels of the two countries, and the real exchange rate would always equal 1. However, since these assumptions are almost never met in the real world, the real exchange rate will never equal 1.

Imagine there are two currencies, A and B. The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries. A government should consider its economic standing, trade balance, and how it wants to use its policy tools when choosing an exchange rate regime. When a country decides on an exchange rate regime, it needs to take several important things in account.

Unfortunately, there is no system that can achieve every possible beneficial outcome; there is a trade-off no matter what regime a nation picks. Below are a few considerations a country needs to make when choosing a regime. A free floating exchange rate increases foreign exchange volatility, which can be a significant issue for developing economies.

Developing economies often have the majority of their liabilities denominated in other currencies instead of the local currency. Businesses and banks in these types of economies earn their revenue in the local currency but have to convert it to another currency to pay their debts. Developing Countries : The developing countries, marked in light blue, may prefer a fixed or managed exchange rate to a floating exchange rate. This is because sudden depreciation in their currency value poses a significant threat to the stability of their economies.

Flexible exchange rates serve to adjust the balance of trade. When a trade deficit occurs in an economy with a floating exchange rate, there will be increased demand for the foreign rather than domestic currency which will increase the price of the foreign currency in terms of the domestic currency.

That in turn makes the price of foreign goods less attractive to the domestic market and decreases the trade deficit.

Under fixed exchange rates, this automatic re-balancing does not occur. A big drawback of adopting a fixed-rate regime is that the country cannot use its monetary or fiscal policies with a free hand.

In general, fixed-rates are not established by law, but are instead maintained through government intervention in the market. The government does this through the buying and selling of its reserves, adjusting its interest rates, and altering its fiscal policies. Because the government must commit its monetary and fiscal tools to maintaining the fixed rate of exchange, it cannot use these tools to address other macroeconomics conditions such as price level, employment, and recessions resulting from the business cycle.

The three major types of exchange rate systems are the float, the fixed rate, and the pegged float. One of the key economic decisions a nation must make is how it will value its currency in comparison to other currencies. An exchange rate regime is how a nation manages its currency in the foreign exchange market.

There are three basic types of exchange regimes: floating exchange, fixed exchange, and pegged float exchange. Foreign Exchange Regimes : The above map shows which countries have adopted which exchange rate regime.

A currency that uses a floating exchange rate is known as a floating currency. The dollar is an example of a floating currency. Many economists believe floating exchange rates are the best possible exchange rate regime because these regimes automatically adjust to economic circumstances.

These regimes enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. However, they also engender unpredictability as the result of their dynamism. A fixed exchange rate system, or pegged exchange rate system, is a currency system in which governments try to maintain a currency value that is constant against a specific currency or good. The central bank of a country remains committed at all times to buy and sell its currency at a fixed price.

This article examines some of the leading factors that influence the variations and fluctuations in exchange rates and explains the reasons behind their volatility, helping you learn the best time to send money abroad. 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.

Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates, and inflation are all correlated.

Increases in interest rates cause a country's currency to appreciate because higher interest rates provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in exchange rates.

It consists of total number of transactions including its exports, imports, debt, etc. A deficit in current account due to spending more of its currency on importing products than it is earning through sale of exports causes depreciation. Balance of payments fluctuates exchange rate of its domestic currency. Government debt is public debt or national debt owned by the central government. A country with government debt is less likely to acquire foreign capital, leading to inflation.

Foreign investors will sell their bonds in the open market if the market predicts government debt within a certain country. As a result, a decrease in the value of its exchange rate will follow. Related to current accounts and balance of payments, the terms of trade is the ratio of export prices to import prices. A country's terms of trade improves if its exports prices rise at a greater rate than its imports prices.