Question

Explain the factors affecting exchange rates in a floating exchange rate system. (more details)

Answer 1

Exchange rates are essentially function of relative comparison of various factors across 2 countries. The key factors affecting the exchange rates are listed below:

a. Inflation Rates: countries with lower inflation will have more purchasing power relative to countries with higher inflation over time, hence lower inflation countries should see their currency appreciate under a floating rate regime.

b. Interest Rates: Though interest rates and inflation are highly correlated; but if we keep inflation constant and under perfect capital mobility, high interest rates will attract foreign capital which will lead to currency appreciation . Hence under floating rate, keeping every thing else constant, high interest rates can lead to currency appreciation. Though in real world, high interest rates are generally accompanied with high inflation also, and the interplay of various factors will not lead to lend to linear exchange rate analysis

c. Current Account & Trade surplus (deficit): If a country has trading surplus with its trading partners, then it will be earning more than it is spending. In this case the demand for its currency will be higher,hence its currency should appreciate (or vice versa in case of trade deficit)

d. Public Debt: Public debt is seen a measure of nation's public finance health and in case of high debt countries, generally the inflation rates will be higher also. Also higher debt increases the default risk thereby making the countries assets less attractive to foreign capital - the cumulative result of this currency loosing value over time.

e. Political Stability and GDP Growth: Foreign capital seeks stable growing countries for investments and the countries which can provide this environment, will be able to attract foreign investments. More the investments (hence more demand for country assets), will lead to higher currency value hence appreciation.