An exchange rate is a rate at which one country trades against another on the foreign exchange market. For example, if the United States exchange rate for the Canadian dollar is $1.55, this means that one U.S. dollar can be exchanged for 1.55 Canadian dollars. If the present exchange rate is one sterling pound for $1.42, in America 10 pounds will get you $14.2 while in the UK $14.2 will get you 10 pounds. Depreciation and appreciation, the former means decrease in the value of a currency while the latter is the increase in value of a currency. The price of a currency is governed by the forces of demand and supply of the same. On the demand factor, an increase in demand means that the currencies in question will experience higher prices. On the other hand, a decrease in demand for the currency will lead to a price fall. An increase in demand has a positive effect on the economy as opposed to a fall in demand.
The demand for a currency is influenced by the prevailing interest rates and inflation, which are regulated by the Federal Reserve of the United States. On the supply factor, the value of a currency will rise and fall with changes in supply. A larger supply diminishes the value of a currency while a lower supply increases its value. The interaction of the demand and supply of a currency helps establish an equilibrium exchange rate; this is called the Demand-Supply Model. When the forces of demand and supply are represented in a graph the equilibrium exchange rate is established at the point of intersection of the two curves. For example, in the diagram below, $1.50 for one pound would be the equilibrium exchange rate.
The equilibrium exchange rates will fluctuate from time to time as demand and supply schedules change. Factors that influence the exchange rates are the determinants of the supply and demand of a currency. Some of the factors that influence exchange rates include differentials in inflation, interest rates, balance of trade, economic stability, government fiscal and monetary policies, public debt, and political stability among others.
Differential inflation rates
The relative inflation rate will have an impact on the supply and demand for currency. The responsibility of controlling inflation lies with Federal Reserve. As inflation increases, every unit of a country’s currency will purchase a smaller percentage of a good or service. For instance, if in the United States, the rate of inflation is 7%, then a $1 bottle of coke will cost $1.07 in a year, therefore 1 dollar would not purchase the whole bottle. Most countries tend to sustain an inflation rate of 2-3%. A low rate of inflation implies that the prices of goods and services are increasing slowly. Foreigners’ demand for these products increased. Higher inflation exhibits depreciation in currency value concerning other countries’ currencies, and vice versa (United States Department of Commerce, 2011).
Decrease in the value of money, fall in the levels of investments and savings in monetary projects and shortages (due to hoarding) of goods are some of the negative effects of inflation (Kaplan, 2011). Inflation is calculated by the use of price indices such as consumer price index, producer price index, commodity price index, and core price index. Producer Price Indexes measure changes in the selling prices of goods and services. In the United States, the consumer price index (CP!) is the most common indicator used by forex traders. The CPI is released monthly, usually between the 13th and 19th of each month. CPI is calculated by the use of a weighing policy. The weighted average prices of goods and services with fixed weights in a basket are taken into consideration. Goods and services in the CPI include food, housing, health care, education, and clothing among others. The core price index excludes food and energy products (Williams, 2006). Core CPI is commonly used by the Federal Reserve as a measure of inflation since it excludes volatile products. For example, in the United States of America, at the beginning of 2007, the consumer price index (CPI) was 202.416 while at the beginning of the following year it was 211.080. Using these values the annual percentage inflation rate over the one year was calculated as 4.28%. Therefore, prices for goods and services in the U.S. in 2007 increased by 4.28%. According to the United States Department of Labor, the CPI increased 0.5% in July after falling 0.2% in June while the CCPI rose 0.2% in July after increasing 0.3% in June (United States Inflation Rates, 2011).
Using formulas, inflation rates can by the same method be calculated using the other price indices. A new price index-Chained Consumer Price Index- has recently been adopted by the U.S. Over the past seven years, the U.S. has experienced a doubling of gasoline prices, losses in the value of homes, low savings, a decline in investments, increased rate of unemployment, changes in the allocation of income and speculative trading. The above graph indicates the levels of inflation during the 2008-2011 periods in the United States. It shows that inflation has increased steadily in the first half of 2011.
Differential interest rates
Interest is the amount charged by a lender to a borrower for use of assets, interest expressed as a percentage is known as an interest rate. Interest rates and exchange rates are intertwined. Interest rate differential is the gap in interest rates between countries over similar assets. A differential in interest rates between two countries has an impact on the exchange rates. The Federal Reserve (Fed) of the United States of America through manipulation of interest rates exerts influence over exchange rates. Due to the slowdown in economic growth in the U.S. during 2001, the Federal Reserve rapidly eased its monetary policy. Changes, made by the Fed, of the rates at which banks borrow money have an impact across the entire economy (Sanchez, 2005). Higher interest means higher returns for investors in a state as compared to other states.
Higher interest attracts foreign investments in form of capital which in turn leads to an increase in the exchange rates. Lower interest rates have the impact of decreasing the exchange rates. A decrease in interest rates lowers the cost of borrowing; which in turn leads to increased investment spending. Lower rates make a common stock more attractive than debt financial instruments, this leads to a rise in common stock prices. This increase in stock prices influences stockholders to invest more with intend of increasing wealth. A higher stock price encourages investments in plants and equipment due to the low cost of borrowing by issuing stock. Interest rates, inflation, and exchange rates are correlated. Therefore, not only does the manipulation of interest rates influence the exchange rates, but it also exerts influence over inflation. When the interest rates of a country are above those of foreign countries, the exchange rate is appreciated above its purchasing power parity level.
When the interest rates are below those of foreign currencies, the exchange rate is depreciated below its purchasing power parity level, hence the relationship between the three (Federal Reserve Bank of San Francisco, 2011). If the Federal Reserve is not focused on containing inflation, traders in the financial markets may due to fear of higher inflation in the future add a risk premium to long-term interest rates, hence increasing the interest rates. In the United States, the exchange rate has been in an up and down movement coinciding with varying interest rate differentials and inflation rates. In the U.S., the current rate tends to determine the investors’ behavior, as the returns in both certificates of deposit and U.S. Treasury bonds are affected by this rate. Increase in rates, investors cut back on spending causing earnings to drop and stock prices to drop. On the other hand, when interest rates have decreased, investors will increase spending, causing stock prices to increase. The current Fed interest rate is between 0 and 25% being dropped by half at the end of 2008. The graph below indicates the interest rates from 2002-2010 in the United States. It can be seen that the interest rates were at a peak in 2007.
Government and Fed interventions
Government controls and Fed intervention are also factors influencing the exchange rates. The government influences the shifting of the equilibrium exchange rate by the imposition of foreign exchange barriers, foreign trade barriers, and through the intervention of the foreign exchange market (Hoang and Whitaker, 2011). In the event of a budget deficit, the government may borrow money from the Fed to pay for the deficit. The Fed issues bonds, these bonds are tradable worldwide, the purchase of these bonds by foreigners in dollars reduces the number of dollars in their countries which in turn reduces the value of the dollar in the foreign countries. Trade barriers, restrictions on free international trade, may be classified into import policies, standards, direct procurement by the government, subsidiaries for local exporters, and restrictions on franchising.
In research undertaken in 1999 and 2005 by PIPA, it was found that a majority of Americans are in favor of the expansion and growth of trade with only a minority preferring implementation of the trade barrier policy. A majority supports the US is playing a leadership role in enhancing trade relations with other countries. A majority also supports the US in its efforts of bringing down trade barriers. Americans are now taking the lead in endorsing free trade agreements with other countries. A controlled exchange rate is usually higher than a free market rate. A controlled rate has the effect of promoting exports and restricting imports. The government through the control authority limits the amount of foreign exchange one can buy to maintain its reserves and foreign balances. When there is severe pressure, the government tends to allow the currency to float toward its market-determined level (United States Department of Labor, 2010).
The Fed can also through the influence of the government revalue its currency against other currencies. Revaluation implies an increase in the exchange rate. The Fed can also affect the dollar’s value indirectly by influencing the factors that determine its value. For instance, the Fed can lower the interest rates by increasing the supply of money keeping inflation constant. The Fed can also increase interest rates by reducing the supply of money. Indirect intervention can be an effective method of influencing the exchange rate. For example, from 1981-1985 the Fed boosted interest to attack inflation and the Reagan authorities financed huge budget deficits. The indirect intervention has also been used to discourage excessive fund outflows thus preventing a fall in the value of money. This has a negative impact on the local borrowers and may weaken the economy. The U.S. is currently involved in an exchange battle with China; the two have been involved in competitive devaluation. China has been reluctant in rising the value of the Chine renminbi, this has affected the U.S. economy. The U.S. is taking the lead in taking measures to cap current account surpluses at a percentage of the national income; this is a tactic intended to increase the value of the Chinese renminbi. Although this initiative has had negative reactions from some of the world’s leading economies, the U.S has reported that the plan is making progress. In a G20 meeting, China criticized Washington, in the U.S., for pumping more money into financial markets thus increasing volatility in exchange rates.
Balance of payments
The balance of payments of a country has a significant effect on the exchange rate. Balance of payments is an accounting record of transactions between one country and other countries over a specified period. It compares the total of foreign currency brought in to the total amount of local currency paid out. A negative balance of payments (BOP) means that more money is paid out of the country than the amount of foreign currency brought in. A positive BOP means that more foreign currency is coming in than the domestic currency flowing out. A country with a positive BOP exhibits significant foreign investment within the country’s boundaries and vice versa. A BOP includes terms of trade and foreign investments. Terms of trade is a ratio comparing imports to exports prices. If the export prices of a country increase at a higher rate than that of import prices, then the country’s terms of trade are positive. An increase in the balance of payment implies an increase in export revenues which eventually leads to an increase in demand for currency; this has the effect of increasing the value of a currency. Balance of payments and terms of trade revolves around a country’s current accounts. A huge current account deficit implies that a country’s import prices are higher than its export prices.
If a country finances this deficit by attracting foreign capital investments its currency will depreciate. For example, in the year between 2006 and 2007, the U.S. dollar faced depreciation due to the 7% of GDP current account deficit. According to the U.S. Department of Commerce (Bureau of Economic Analysis) in the first quarter of 2011, the U.S. current account deficit which includes: the combined balances of trade in goods and services, and net current transfers, increased from $112.2 billion (in the fourth quarter of 2010) to $119.3 billion. The value of exports increased from $159.2 billion in the fourth quarter of 2010 to $182.5 billion in the first quarter of 2011. Growth in petroleum and products and nonferrous metals accounted for almost 80% of the increase. The value of imports increased from $501.9 billion to $543.8 billion. Foreign-owned assets in the U.S. increased to $507.1 billion from $266.6 billion United States Department of Labor 2010. U.S. liabilities to foreigners also showed a significant increase. For the last decade, the Bureau of Economic Analysis (BEA) has made various revisions and changes to the U.S. international transaction accounts by introducing new definitions and classifications (U.S. Inflation Calculator, 2011).
For instance, Exports and imports of goods during the period 1999-2009 were revised to introduce seasonal adjustments to the balance of payments. The above data shows that the U.S. government is facing up to huge current account deficits and budget deficit problems, thus facing economic crises. A balance of payment deficit does not necessarily mean that a country’s economy is weak, and a surplus does not automatically mean that the economy is strong. A surplus indicates an economy that is a net creditor to other countries; a country is saving as opposed to investing. On the other hand, a deficit indicates an economy that is a debtor; the country is investing more than it’s saving. A deficit, therefore, represents a rise in investments from abroad which has positive effects on the local economy in the long run. Many researchers suggest that the current growth in the U.S. current account deficit is unsustainable in the medium-term. This growth has been consistent since 1990 when the investment was low. From 1991 onwards, due to the Asian financial crisis, the U.S. became relatively more attractive to investors which resulted in a decline in the current account. A decline in the rate of private savings has also had its part in the decline of the current account since 1990. This consistent decline in the current account has led to an increase in oil prices and prices of goods and services.
Current accounts and public debt
Debt is important to both businesses and economies but must be controlled and managed efficiently to prevent disastrous effects. While public debt stimulates the growth of the local economy, countries practicing debt financing are less attractive to foreign investments. The U.S. finances most of its public projects by issuing debt instruments, this has further led to a decline in the current account. As of August 10, 2011, the U.S. debt was nearly over $14.5 trillion, two-thirds of this is public debt owed mainly to businesses and foreign governments who own treasury bills and bonds. This amount is the largest in the world, with the major foreign investors being China and Japan. The U.S. debt grew by 50% between 2000 and 2007 averaging $6-9 trillion. In December 2008 the debt grew to $10.5 trillion due to the $700 billion bailout. Interest on the debt was $414 billion for the financial year 2010, higher than that of 2009 which was $383 billion. The economy benefited from the increased deficit spending in the short run. The debt holders in turn demand higher interest rates to compensate for the increased risk associated with deficit spending.
To control the increased interest rates payments the U.S. government exercises a debt ceiling which is aimed at limiting the debt. However, this is sometimes raised to curb the effects of debt default. As a result, foreign countries such as China and Japan increased their holdings which grew from 13% in 1988 to 31% in 2011. On the total holdings, China owns $1.1 trillion while Japan owns $900 billion; the U.K. owns $300 billion. This increase in debt has left the U.S. government with the option of increasing tax rates to finance the Social Security Funds. Researchers estimate that more than 50% of foreign holders will invest more in their domestic economies as opposed to that of the U.S (U.S. Department of Treasury, 2011). As a result, the demand for the dollar would decrease thus putting downward pressure on the dollar. Foreign holders are then paid less which further decreases demand. The huge public debt is becoming more risky, further slowing the U.S. economy (U.S. Commerce Department press release, 2011).
Foreign investors tend to invest more in stable countries with growing economies. Political stability is therefore significant to a country’s economy. The U.S. has over the next ten years decided to cut federal spending, but according to a former U.S. economic official, this would cause social injustice and political instability.
Speculation of anticipated exchange rates directly affects the current exchange rate. Speculation is the deliberate assumption of risk to obtain profit. Rational speculation stems from the assumptions of incomplete asset markets and segmented product markets, which do not appear in many exchange rate models (U.S. Department of Commerce, 2011). This allows for changes in exchange rates without much change in the prices of goods and services. In exchange rate forecasting, the assumption of risk neutrality is made. The assumption of indifference between holding domestic and foreign assets and liabilities is made. In forecasting, some variables such as differentials in interest rates are assumed to be constant. That is interest rates between two countries are equal. Forecasting can be in form of a probability distribution, where through mathematical calculations expectations of appreciations or depreciation of a currency are determined. Investors make investment decisions based on these calculations.
A reduction in the purchasing power of income and a decrease in capital gains are a result of a fall in exchange rates. Investors should have in mind the significance of currency value and exchange rates while evaluating the rate of return on their investments in foreign countries. Though the United States economy has had its moments over the past years, the stability of the USD has been evident. The stability of the U.S. dollar brings about peace of mind to investors. The U.S. dollar has never been devalued, and because of this, the U.S. dollar is becoming the worldwide currency of choice taking over from the sterling pound. It is estimated that 40-60% of existing U.S. dollars are in circulation outside the U.S. Stability, acceptability and anonymity are some of the reasons for the unofficial dollarization. Despite its popularity, the U.S dollar has like many other currencies shortcomings of counterfeiting, especially the $100 note. This popularity has had a major influence on the value of the U.S. dollar-based on increase in demand for the currency.
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