What are the Factors which Influence Rate of Exchange?

Different theories of exchange rate determination attempt to explain only the equilibrium or normal or long period rates of exchange. The market or the day-to-day rates of exchange, however, are subject to fluctuations in response to the changes to the supply and demand for international money transfers.

There are a host of factors which influence the supply of and demand for foreign exchange and thus are responsible for the fluctuations in the rate of exchange. Important among them are given below:

1. Trade Movements:

Changes in the imports and exports cause changes in the demand for and supply of foreign exchange which in turn, lead to fluctuations in the rate of exchange.

If the imports exceed exports, the demand for foreign exchange increases and, as a result, the rate of exchange of native currency will fall and move against the native country.

On the other hand, if exports exceed imports, the demand for foreign exchange decreases and the rate of exchange rises and moves in favour of the native country.

2. Capital Flow:

Capital flow from one country to another brings changes in the rate of exchange. If, for example, capital is exported from America for investment in India, the demand for India rupee will increase in the foreign exchange market. As a consequence, the rate of exchange of Indian rupee in terms of American dollar will rise.

3. Granting of Loans:

If a country gets loans from some foreign country, the supply of the foreign currency will increase. As a result, the rate of exchange will move in favour of the home currency and against the foreign currency.

But, at the time of repayment of loan or granting loan to the foreign country, the supply of foreign currency will fall and the rate of exchange will move against the home currency and in favour of the foreign currency.

4. Sale and Purchase of Securities:

Sale and purchase of foreign securities influence the demand for foreign exchange, and, thereby, the exchange rate. When the residents of a country purchase foreign securities, the demand for foreign currency Increases.

As a result, the value of home currency falls, i.e., the rate of exchange moves against the home currency and in favour of foreign currency.

5. Banking Operations:

Banks are the dealers in foreign exchange. They sell drafts, transfer funds, issue letters of credit, and accept foreign bills of exchange.

When a bank issues drafts or other credit instruments on its foreign branches, it increases the supply of home currency in the foreign exchange market.

As a result, the rate of exchange moves in favour of the home currency and against the foreign currency.

6. Speculation:

Speculation (or anticipation about the future changes) in the foreign exchange market also causes variations in the rate of exchange. If the speculators expect the value of foreign currency to rise, they begin to buy foreign currency in order to sell it in future to earn profit.

By doing so, they tend to increase the demand for foreign currency and raise its value. On the other hand, if the speculators anticipate a fall in the future value of foreign currency, they will sell their foreign exchange holdings.

As a result of this increase in the supply of foreign exchange, the rate of exchange will move against foreign currency and in favour of home currency.

7. Protection:

When the government of a country gives protection to the domestic industries, it tends to discourage imports from other countries. As a consequence, the demand for foreign currency will decrease and the rate of exchange will move in favour of the home currency and against the foreign currency.

8. Exchange Control:

The policy of exchange control also brings about changes in the rate of exchange. Generally, various measures of exchange control involve restrictions on imports which lead to a fall in the demand for foreign currency. As a result, the rate of exchange moves in favour of the home currency and against the foreign currency.

9. Inflation and Deflation:

Changes in the internal value of money also reflect themselves in the similar changes in the external values. During inflation, the internal value (or the purchasing power) of home currency falls and there will be outflow of foreign capital from the country to avoid financial losses.

As a result, the demand for foreign currency will increase and the external value of home currency will fall.

On the contrary, during deflation, the internal value (or the purchasing power) of the home currency rises and there will be inflow of foreign capital to realise financial gains from the relative appreciation of the value of foreign currency and a change in the exchange rate in favour of home currency and against foreign currency.

10. Financial Policy:

Policy of deficit financing leads to inflationary conditions in the country. As a result, the foreign capital will start leaving the country, the supply of foreign exchange will fall and the rate of exchange will turn in favour of foreign currency and against home currency.

11. Bank Rate:

Changes in the bank rate cause fluctuations in the exchange rate. When the central bank of a country raises the bank rate, there will be inflow of foreign capital with a view to earn higher interest income.

As a result, the supply of foreign currency increases and the rate of exchange moves against the foreign currency and in favour of home currency. On the other hand, when the bank rate is reduced, there will be an outflow of foreign capital.

This reduces the supply of foreign currency and the exchange rate moves in favour of the foreign currency and against the home currency.

12. Monetary Standard:

If the country is on the gold standard, then the exchange rate will move within the limits set by upper and lower gold points. On the contrary, in a country with inconvertible paper money system, there is no limit to the fluctuations in the rate exchange.

13. Peace and Security:

The conditions of peace and security in the country attract foreign capital. This increases the supply of foreign currencies in the country and the rate of exchange moves against the foreign currencies and in favour of the home currency.

14. Political Conditions:

Political stability also encourages inflow of foreign capital in the country. As a result, the supply of foreign currencies increase and their value in terms of home currency falls.

All these factors cause fluctuations in the exchange rate only in the system of flexible exchange rates. However, if the country adopts the policy of complete exchange control, and the exchange rate is pegged at a certain level, there will be no variations in the rate of exchange.