The various theories of exchange rate determination, as we have seen, seek to explain only the equilibrium or normal long period exchange rates. Market rates (or day-to-day rates) of exchange are, however, subject to fluctuations in response to the supply of and demand for international money transfers.
In fact, there are various factors which affect or influence the demand for and supply of foreign currency (or mutual demand for each other's currencies) which are ultimately responsible for the short-term fluctuations in the exchange rate. Important among these are:
1. Trade Movement
Any change in imports or exports will certainly cause a change in the rate of exchange. If imports exceed exports, the demand for foreign currency rises; hence, the rate of exchange moves against the country. Conversely, if exports exceed imports, the demand for domestic currency rises and the rate of exchange moves in favour of the country.
2. Capital Movements
International capital movements from one country to another may either be for short periods avail of the high rate of interest prevailing abroad or for long periods for the purpose of making Ion term investment abroad.
Any export or import of capital from one country to another will bring about a change in the rate of exchange. Say, if a large amount of capital is shifted from England to India, the demand for Indian rupees (or the supply of British pounds) in the exchange market increases so that, the exchange value of the rupee in terms of pound increases. That is to say, rupee will appreciate in value in terms of pounds. The reverse will happen when there is a flight of Indian capital England.
3. Stock Exchange Operations
These include granting of loans, payment of interest on foreign loans, repatriation of foreign capital, purchase and sale of foreign securities, etc., which influence demand for foreign funds and through it the exchange rates. For instance, when a loan is given by the home country to a foreign nation, the demand for foreign money increases and the rate of exchange tends to move unfavourably for the home country. But, when foreigners repay their loan, the demand for home currency exceeds its supply and the rate of exchange becomes favourable.
4. Speculative Transactions
These include transactions ranging from anticipation of seasonal movements in exchange rates for the extreme one, viz., flight of capital. In periods of political uncertainty, there is heavy speculation in foreign money. There is a scramble for purchasing certain currencies and some currencies are unloaded. These speculative activities bring about wide fluctuations in exchange rates.
5. Banking Operations
Banks are the major dealers in foreign exchange. They sell drafts, transfer funds, issue le of credit, accept foreign bills of exchange, take up arbitrage operations, etc. These operations infill the demand for and supply of foreign exchange, and hence, the exchange rates.
Bank rate also exerts a significant influence on the rate of exchange. A rise in bank attracts foreign funds, hence, the demand for home currency rises and the rate of exchange m up: The opposite happens when the bank rate is lowered.
6. Monetary Policy
An expansionist monetary policy has generally an inflationary impact, while a contract1 policy tends to have a deflationary influence. Inflation and deflation bring about a change if internal value of money. This reflects itself in a similar change in the external value of m' Inflation means a rise in the domestic price level, fall in the internal purchasing power of money, and hence, a fall in the exchange rate. Oh the other hand, a deflationary policy leads to a fall domestic prices and rise in the exchange rate.
7. Political Conditions
Political stability of a country can help very much to maintain a high exchange rate for its currency; for it attracts foreign capital which causes the foreign exchange rate to move in its favour. Political instability, on the other hand, causes a panic flight of capital from the country, hence, the home currency depreciates in the eyes of foreigners, and consequently its exchange value falls.
In fact, political conditions in a country are a potent factor both in exchange speculation and in the international movement of capital.
However, fluctuations in the rate of exchange in the short period are confined within certain limits. Under the gold standard system, these limits were set by gold or specie points as determined by the mint par.
Under inconvertible paper standard, however, the purchasing power parities of the two countries set such limits. The purchasing power par, however, unlike the mint par, is not fixed. It is a moving par, and therefore, movements in the rate of exchange in paper standard are not confined to definite limits. Hence, the variations will depend upon the magnitude or force of change in the demand and supply condition of foreign exchange.