Factors That Determine a Currency’s Value Essay Sample

Increasing exchange rate fluctuations. such as those that have occurred in the US dollar. have late revived the treatment about the causes of such motions and the standards for ciphering the long-run over- or undervaluation of a currency. Currency can be defined as any signifier of money that is in public circulation. Currency includes both coins and soft money paper money. Typically currencies are used as a medium of exchange for goods and services. The exchange rate indicates the monetary value of a currency and plays hence an of import function. [ 1 ] Besides when puting or buying in a foreign currency. it is of import to understand the factors that determine a currency’s value. Investors are frequently exposed to different currencies. companies have abroad net incomes. and many financess invest abroad. Exchange rate motions will therefore impact the returns of a concern. [ 2 ] In the following this paper examines several factors that influence a currency’s value.

Factors that determine a currency’s value

1 Inflation

The first facet that influences a currency’s value is the rising prices. Inflation can be defined as the overall general upward monetary value motion of goods and services in an economic system. [ 3 ] Inflation is being measured by the rising prices rate. The rising prices rate is determined by the per centum rate of alteration in monetary value degree over clip and can be defined as follows:

Inflation rate = [ P ( T ) -P ( t-1 ) ] / P ( t-1 ) *100 %

A larger sum of currency in circulation can take down the value of that currency. That means if the supply of goods and services does non increase or non increases every bit much as the supply of money. the monetary values for goods and services will travel up. [ 4 ] Besides when mentioning to rising prices. Buying Power Parity plays an of import function. PPP is being defined as “An economic theory that estimates the sum of accommodation needed on the exchange rate between states in order for the exchange to be tantamount to each currency’s buying power. ” [ 5 ] PPP provinces that a nation’s currency and its general monetary value degrees are supposed to travel in opposite waies. [ 6 ] If PPP holds and the differential rising prices rates between states are precisely offset by exchange rate alterations. countries’ competitory places in universe export markets will non be consistently affected by exchange rate alterations. If there are divergences from PPP. alterations in nominal exchange rates cause alterations in the existent exchange rates which affect the international competitory places of states. Consequently this affects countries’ trade balances. [ 7 ]

The comparative rising prices rate affects international trade activity. which influences the demand and supply of foreign currencies. For illustration if U. S. rising prices additions. there will be a higher U. S. demand for British goods and hence demand for Pound. At the same clip there will be a lower British desire for U. S. goods. and therefore supply of Pound. [ 8 ]

In America a slow in rising prices of foreign goods keeps monetary values of those goods stable. This allows American consumers to buy the same sum or more of the same goods. As a effect. the dollar may be weakened. Besides the trade shortage can’t be closed. Furthermore. intelligence and outlooks about possible rising pricess for case of the dollar. cause reactions. The foreign exchange market may respond preemptively and fluctuate the dollar. [ 9 ] To sum up. it can be said that the currency of a state with lower rising prices than its trading spouses should beef up over clip. Besides it will keep its “purchasing power” better than its equals. The hankering has been the best acting major currency of the past 20 old ages. It is being said that the hankering is being “overvalued” . but Japan’s systematically low rising prices rate over this period could travel some manner to explicating its strength. [ 10 ]

2 Interests rates

Besides involvement rates influence the value of a currency. There exist two different types of involvement rates- existent and nominal involvement rates. The nominal involvement rate has no rising prices factored in. The existent involvement rate can be described as:

Real Interest Rate= Nominal Rate – Rate of Inflation [ 11 ]

In general a higher involvement rate means a higher demand for a currency. Foreign investors ever look for the higher involvement. Consequently the higher demand for a currency leads to an addition in its value. [ 12 ] Interest rate derived functions in currencies lead to ‘carry trades’ . Here. investors borrow the low involvement rate currency and they so exchange it for a higher involvement rate currency. The former currency weakens whereas the last currency will beef up. [ 13 ]

In the following it will be analyzed how comparative involvement rates affect a currency’s value. Relative involvement rate affects the international capital flow. which influences the demand and supply of foreign currencies and exchange rates. For illustration a higher U. S. involvement rate leads to a lower U. S. demand for British bank sedimentations and therefore leads to a lower demand for the other currency. in this instance the Pound. However. it leads to a higher British desire for U. S. bank sedimentations and therefore the supply of Pound. [ 14 ]

Furthermore. the currency’s value of one state is besides being influenced by attractive involvement rates in other states. If the involvement rates of the US for case are lifting or falling. the dollar’s value besides depends on how US involvement rates stack up to those of other states. If the involvement rates of the US for case are lower. investors are likely to exchange to different currencies that can offer a better return. If the US on the other manus has attractive involvement rates. this will pull investors.

Besides outlooks about involvement rates play an of import function. The release of intelligence may take to a fluctuation of the dollar harmonizing to the coming influx or escape of investings that are expected to go on in the hereafter. [ 15 ]

A para status which is frequently being encountered in literature is the Fisher Effect ( FE ) and the International Fisher Effect ( IFE ) . The FE holds that “an addition ( lessening ) in the expected rising prices rate in a state will do a relative addition ( lessening ) in the involvement rate in the state: 1+i = ( 1+p ) * ( 1+E ( ? ) ) [ 16 ]

The IFE suggests that the nominal involvement rate differential reflects the expected alteration in exchange rate. for illustration: Tocopherol ( vitamin E ) = one $ -i?
For case if the involvement rate is 6 % per twelvemonth in the US and 8 % in the UK. the dollar is expected to appreciate against the British lb by about 2 % per twelvemonth. [ 17 ]

3 Trade and Investment

If person wants to purchase a country’s goods or invest in its stock market. the first measure is to purchase the country’s currency. Consequently exchange rates respond to merchandise and investing flows. One scenario is a state with bettering economic chances. This state is likely to pull capital from investors. A effect is an addition in demand which should take to a stronger currency. [ 18 ]

Balance of trade
The balance of trade is besides known as the current history balance. The trade balance is equal to the difference between imports and exports. To use this to an illustration. the US has been running a trade shortage [ 19 ] with the remainder of the universe for most of recent memory. The trade shortage is presently $ 2 billion a twenty-four hours and turning. Consequently the shortage is doing foreign investors progressively nervous and can impact the dollar significantly. The broadening of the trade shortage in the U. S. within in the last old ages is represented in Figure 1.

Figure 1: US Trade Deficit ( % GDP ) . [ 20 ]

Falling monetary values on foreign goods
A trade shortage is created by diminishing foreign monetary values for goods as those goods become more attractive to American consumers. On the other manus. if a natural monetary value rising prices or increased demand lead to a rise in monetary values of foreign goods more American goods might be consumed. This will assist to contract the trade shortage and it serves to assist the dollar.

Balance of investing
When the US imports more than it exports. it means investors from other states have to purchase US assets to maintain the dollar from falling. Simply stated. if the US imports more than it exports. foreign investors must purchase dollar-denominated assets like bonds or exchequer securities in order to countervail the difference. [ 21 ]

4 Economy

1 Economic indexs

Other factors act uponing a currency’s value are economic indexs. Those are studies which are being released by the authorities or a private organisation and where a country’s economic public presentation is being reported. Each of the indexs being publicized is really of import. Changes in the conditions reported will straight impact the monetary value and volume of a country’s currency. It is of import to understand the significance of the Numberss and their influence on the value of a currency.

Gross Domestic Product ( GDP )
GDP represents the entire market value of all goods and services produced in a state during a given twelvemonth. Most bargainers focus on the progress and the preliminary study [ 22 ] as the GDP itself is frequently a lagging index. As it is a step of growing. it is an of import economic index which could impact a currency’s value. GDP growing rate:

GDP ( T ) = C ( T ) + I ( T ) + G ( T ) + NX [ 23 ]

Retail Gross saless
In the Retail Gross saless report the entire grosss of all retail shops in a state are being measured. This study is a timely index of wide consumer disbursement forms adjusted to seasonal variables. The public presentation of more of import lagging indexs can be predicted and the economic state of affairs of a state can be assessed.

Industrial Production
Industrial Production shows the alteration in production of mills. mines and public-service corporations within a state. Besides the grade to which the capacity of each of these mills is being used is reported. The purpose for a state is to see an addition of production while the maximal capacity use is being used. If there are important alterations between studies caused by conditions alterations for illustration. this can take to volatility in the nation’s currency. Consumer Price Index ( CPI )

The alteration of monetary values of consumer goods is being is being measured by the CPI. It helps to see if a state is doing or losing money with its merchandises or services. [ 24 ]

2 Economy and Economic Theory

Another decisive factor is the inquiry whether or non an economic system is in a growing or recession period. In growing periods there is an addition in a currency’s value. in recession a lessening. A higher demand raises the value and an addition in money supply can take to a lessening of the value. [ 25 ] With every new dollar for case which is being printed. each dollar is being valued less than earlier. This normally leads to rising prices which straight eats into the value of the dollar. [ 26 ]

3 Industry

Industries like fabrication and service industries are besides of import facets of how a nation’s currency is valued. Strong growing in fabrication sectors will do investors being more resolute. while a fabricating lag will do them precautious.

Besides. high employment rates lead to a stronger currency as a authorities is guaranteed more revenue enhancements to run expeditiously. [ 27 ] To take as an illustration. American industry both affects and reacts to the value of the dollar. When the dollar falls. goods in America become cheaper and more attractive. However. when the value of the dollar is being increased. American industries have to vie harder against cheaper foreign labour and goods. Besides an industry lag means a general deceleration in the economic system and can do investors to go wary of the dollar. In contrast. a strong fabrication growing can make a more attractive dollar. Furthermore. outsourcing creates a trade shortage. This causes US employment to endure. which consequences in a lessening of the dollar. However. outsourcing besides makes US companies more profitable and more attractive marks for foreign investing. Entrepreneurship creates attractive investing chances for foreign investors. back uping a stronger dollar. Finally higher or lower rewards can either pull or frighten off investors. making a fluctuation in the dollar’s value. [ 28 ]

5 Government policy

Politicss play an of import portion in a currency’s value. Budget shortages. geopolitical events. consumer revenue enhancement cuts and entitlement plans determine the value. If a authorities has policies that weaken its economic system or its control over the market. other states will detect the alterations. [ 29 ] Governments act upon the equilibrium exchange rate by: • Intervening in the foreign exchange market

• Imposing foreign exchange barriers
• Imposing foreign trade barriers
• Influencing macros variables such as rising prices. involvement rates and income degrees. [ 30 ] Government intercession takes topographic point either in a direct or indirect manner. A authorities will straight step in in the foreign exchange market. if a cardinal bank exchanges its currency clasp as militias for foreign currencies. This can be done in two different ways. For illustration. the US Federal Reserve can weaken ( strengthen ) the US dollar by purchasing ( selling ) foreign currency while selling ( purchasing ) US dollar. As the cardinal Bankss do non set for the alteration in money supply. this procedure can be considered non-sterilized. If the Federal Bank. nevertheless. sells ( to weaken US dollar ) or buys ( to beef up US dollar ) exchequer securities to or from fiscal establishment. it intervenes in a sterilised manner because it engages in countervailing minutess to keep the money supply. In contrast. indirect intercession means that cardinal Bankss influence factors impacting the currency’s value such as involvement rates or income degrees as mentioned above. [ 31 ]

Furthermore. the government’s budget can impact the currency’s value. If a state is passing more money than it has available. foreign investors know that the state has to borrow from future coevalss and from the private sector. When the authorities keeps a good recognition history. hazard goes down and the value of the currency goes up. Terrorist onslaughts and war harm consumer and concern assurance. economic growing is being hindered. Furthermore it makes investors nervous because it will probably increase the national debt. and somewhat increase the hazard of default. Besides geopolitical events play a function. The value of a currency will be negatively affected if a struggle or foreign engagement is being precipitated. Consistent policies lead to higher investings in that state. Demand is being increased and therefore the value of the currency. As elections take topographic point. the economic system can be affected. Assurance or chariness can do investors to flock to or fly from the dollar. Tax cuts for consumers increase disbursement. which can better the economic system of a state. This will be positive for a currency every bit long as it does non intensify the trade shortage or budget shortage. Increases in revenue enhancements nevertheless deter consumer disbursement. but they help with authorities disbursement and debt. This can decelerate the economic system. but at the same clip lessen shortages of a state. [ 32 ]

6 Other factors act uponing a currency’s value

Apart from the indexs mentioned. there are legion other factors impacting a nation’s currency. Those factors will be presented in the followers.

First of all. the conditions can hold an influence on a currency’s value. Weather affects agribusiness. industry. energy ingestion and local economic systems. For illustration unfavourable agrarian conditions can ensue in slow harvests. As a consequence force grocers may to other states to fulfill US agricultural demands. A trade shortage is being opened and the dollar weakened. Another ground for a alteration in currency’s value can be an remarkably hot summer that can do a rise in energy costs. Industries every bit good as consumer might be affected. As a consequence the Dollar may diminish because the currency will fight as a batch of money has to be spent on alleviation and rebuilding. [ 33 ] Besides publishing a high sum of currency can diminish the value of the currency. In contrast. a little sum of currency in circulation can take to an addition in the value of the currency. [ 34 ] In add-on. a lodging roar or flop can drop the value of places. A deceleration of the lodging market means that if sellers’ inquiring monetary values will be less this will take to a lower sum of consumer disbursement. This will ensue in lower demand for the currency. A turning. steady lodging market builds the equity and net worth of place proprietors. Higher disbursement leads to growing of the economic system which supports the dollar. An overinflated lodging market will ensue in a autumn of equity and personal wealth. It makes the dollar autumn every bit good. [ 35 ]

Positive or Negative Percept of buyers comprehending old discussed parametric quantities can act upon the demand for a currency. When investors are optimistic about the planetary economic system. money tends to flux into more “risky” assets. frequently denominated in higher involvement rate and emerging market currencies. If concerns originate. money tends to flux more to assets that are being perceived as “safe havens” . Those are bonds issued by the US and Nipponese authoritiess. Therefore the dollar and yen tend to make good in times of convulsion. [ 36 ]

Decision

To reason. it can be said that the foreign exchange market is tremendous. It is being estimated that about US $ 4 trillion alteration custodies daily. between cardinal Bankss. retail and investing Bankss. institutional investors. companies. authoritiess and retail investors. Therefore many concern determinations are being made based on implicit or expressed prognosiss of future exchange rates. Forecasting exchange rates every bit accurately as possible is of import for currency bargainers and transnational corporations. [ 37 ] After analysing the factors that determine a currency’s value. it can be concluded that a batch of differing factors play a function and have to be determined. Besides Investors shouldn’t overlook the impact of currencies on their investings. and should see exchange rates as a hazard every bit good as an chance. [ 38 ]

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[ 1 ] hypertext transfer protocol: //www. investorwords. com/1240/currency. hypertext markup language
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[ 12 ] Articlesbase: A List of Factors which determine Currency Value ; October 2009. [ 13 ] Hargreaves Lansdown: What determines a currency’s value ; November 2011. [ 14 ] Cheol S. Eun. Bruce G. Resnick: International Financial Management. [ 15 ] Currency Trading: 50 Factors that Affect the Value of the US Dollar ; August 2007. [ 16 ] i=nominal involvement rate. p=real involvement rate. E ( A ) = expected rising prices rate. [ 17 ] Cheol S. Eun. Bruce G. Resnick: International Financial Management. p. 149. [ 18 ] Hargreaves Lansdown: What d? ) = expected rising prices rate. [ 19 ] Cheol S. Eun. Bruce G. Resnick: International Financial Management. p. 149. [ 20 ] Hargreaves Lansdown: What determines a currency’s value ; November 2011. [ 21 ] Trade shortage means that imports exceed exports.

[ 22 ] Dr Pinna: Trade Deficit widens 33 % ; February 2011.
[ 23 ] Currency Trading: 50 Factors that Affect the Value of the US Dollar ; August 2007. [ 24 ] The progress and the preliminary study are being issued in the months before the concluding GDP figures. [ 25 ] C=Consumption. I=Investment. G=Government Spending and NX=Net Exports ( Export-Import ) . [ 26 ] Finance Yahoo: Cardinal Factors that Affect Currency Values ; November 26th 2011. [ 27 ] E How: Factors that Affect Currency Value ; November 2011. [ 28 ] Currency Trading: 50 Factors that Affect the Value of the US Dollar ; August 2007. [ 29 ] E How: Factors that Affect Currency Value ; November 2011. [ 30 ] Currency Trading: 50 Factors that Affect the Value of the US Dollar ; August 2007. [ 31 ] E How: Factors that Affect Currency Value ; November 2011. [ 32 ] Lecture Notes: International Parity Conditions and Exchange Rate ( Chapter 6. Skid 9 ) . [ 33 ] Lecture Notes: International Parity Conditions and Exchange Rate ( Chapter 6. Slide 14-15 ) . [ 34 ] Currency Trading: 50 Factors that Affect the Value of the US Dollar ; August 2007. [ 35 ] Currency Trading: 50 Factors that Affect the Value of the US Dollar ; August 2007. [ 36 ] Articlesbase: A List of