Exchange Rate Determinants
Financial managers of Multinational companies constantly monitor exchange rates because their cash flows are highly reliant on currency rates. As economic conditions change, exchange rates can change substantially and adversely affect company’s value. Here we will review some factors that influence exchange rates.
The first factor is inflation rate. Changes in inflation rates can affect international trade activity, which influences the demand for and supply of currencies and therefore influences exchange rates. For example a higher inflation rate in the UK compared to other countries will tend to reduce the value of pound because prices of goods and services in the UK are increasing at a comparatively quicker pace. These goods and services then appear more expensive in the eyes of foreigners, which in turn decreases demand for UK exports. Therefore there will be less demand for Pound Sterling. Also, UK consumers will find it more attractive to buy European imports. Therefore they will supply pounds to be able to buy Euros and the Euro imports. This increase in the supply of pounds decreases value of Pound Sterling.
The second factor is interest rates. Changes in relative interest rates affect investment in foreign securities, which influences the demand for and supply of currencies and therefore influences exchange rates. Investors will invest their funds where, for a given level of risk, the returns are highest. Thus, when a difference in interest rates exists between countries whose risk of default is equal, investors would likely lend to the country that was offering the higher interest rate. In order to invest in or lend to another country, one must first obtain that nation’s currency. This increases demand for that nation’s currency, and causes it to appreciate in value.
A third factor affecting exchange rates is relative income levels. Because income can affect the amount of imports demanded, it can affect exchange rates. Assume that the U.S. income level rises substantially while the British income level remains unchanged. In this scenario the demand for pounds will increase, reflecting the increase in U.S. income and therefore increased demand for British goods. Second, the supply of pounds for sale is not expected to change. Therefore, the exchange rate of the pound is expected to rise.
A fourth factor affecting exchange rates is government controls. The governments of foreign countries can influence the equilibrium exchange rate in many ways, including:
(1) imposing foreign exchange barriers,
(2) imposing foreign trade barriers,
(3) intervening (buying and selling currencies) in the foreign exchange markets, and
(4) affecting macro variables such as inflation, interest rates, and income levels.
The other important factors are political and economic factors. Most investors are risk-averse. They will invest their funds where there is a certain level of certainty. They tend to avoid investing in countries that are typified by governmental instability and/or economic stagnation. In contrast, they will invest capital in stable countries that exhibit strong signs of economic growth. A nation whose government and economy are perennially stable will attract the most investment. This, in turn, creates demand for that nation’s currency and causes its currency to appreciate in value.