Exchange Rate

Aybey Boran

In a floating exchange-rate environment, the exchange-rate responds to many factors. According to me, there are two types of factors long term factors and short term factors.

Long term factors are, production and consumption, trade balance deficit, trade balance surplus, productivity, government dept and government deficit, national savings.

Production and consumption; When a country has some real growth in production, normally it should not increase its money supply. But, this is the very time governments need money the most. Only few can stop the impulse to print a little extra to tide them over. If a government does not control to guarantee that no money is produced unless some production takes place, that currency will definitely fall in value compared with currencies that are based on more productive.

Government dept: Governments has to pay for public sector projects and governmental funding. Nations with large public deficits and debts are less attractive to foreign investors. A large debt encourages inflation, for example, if inflation is high, the debt will be eventually paid off with cheaper real dollars in the future. Government may try to print money to pay part of a large debt, but increasing the money supply causes inflation. And, if a government is not able to service its deficit selling domestic bonds, then it must increase the supply of securities for sale to foreigners which means lowering their securities prices. Finally, a large debt may cause worry to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to buy securities in that country’s currency if the risk of default is too much. Thus, the country's debt rating is an important factor of its exchange rate.

Trade Balance: When two countries trade with each other, it is not possible that the sum of the imports and exports between them will add to zero. A deficit in the trade balance shows the country is spending more on foreign trade than it is earning, country requires more foreign currency than it receives through sales of exports. The demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners.

National savings: If a nation is composed of individuals who save a greater proportion of their earnings than other countries, this adds strength to the currency of the country. National savings can be used to finance debt instead of borrowing abroad. National savings which are deposited in to the banks provides capital for the economy.

Productivity: Productivity is the amount of gross national product per person. This is one area in which the U.S. is still very strong. Somehow, productivity in Japan is very low. Exporting productivity in Japan is very high but I can’t say the same thing for farming and domestic distribution in Japan.

Short term factors are inflation, interest rates, real return on investment, velocity.

Inflation; Inflation occurs when the rate of money growth in an economy is higher than the rate of growth in real GDP. A country with a steady lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies.

Interest rates: Inflation and interest rates are all correlated. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down.

Real return on investment: Knowing the real return within a currency can help you understand the real profit you have made in your own spendable currency and real returns can help you choose currencies in which to invest. One of the short term factors of a strong currency is having a high real return.

Velocity: The velocity of a currency measures how rapidly the currency is currently strengthening or weakening. This velocity calculation can help us measure future tendencies of strength or weakness in currencies. A currency's current velocity is self fulfilling because investors tend to invest in currencies that are rising in value. Thus if a currency is rising, it is more likely to continue to rise.