An exchange rate is the worth one currency in terms of the
other. The value of an US Dollar in terms of Euros calculates how much dollar
is needed to buy one pound in the international market. When the exchange rate
is calculated by the demand for and the supply of foreign currency, it is known
as flexible exchange rate. This is just the opposite of the fixed exchange rate
system where government intervenes to maintain the currency’s value in a very fine
band.
Determining Exchange
Rates
Based on the exchange rate we can calculate whether a
country’s currency depreciates or appreciates. A country’s currency appreciates
if its value arises in terms of the other currency and depreciates if its value
reduces in terms of the other currency.
Let us discuss some of the important factors that calculate
the floating exchange rate:
Inflation Rate
Differential: Countries with better inflation rate (where the price levels
are arising at a faster rate) have a depreciation of their currency related to
their trading partners.
Interest Rate
Differential: International investors are interested to invest in a
currency of better interest rate in order to enjoy a higher rate of return. Therefore
higher interest rate attracts foreign capital and appreciates the currency.
National Debt or Budget Deficit: A budget deficit happens
when the government is spending more than what it is earning. A county with
mounting national debt generally deter the foreign direct investment and
thereby decrease the value of their currency.
Economic Growth and
Political Stability: A stable economic growth of a country enhances the
investor’s confidence to invest and thus tends to appreciate the currency in
the international market.
Other factors like terms of trade, business cycle, sudden
terror attack or war also have major contribution on the exchange rate calculation.
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