How are Exchange Rates determined ? - Part 1

Have u ever wondered why it takes INR 40.5 (approximately) to get 1 US Dollar (1 USD). Ever wondered why it was INR 43.5 about 6 months back and getting the USD is cheaper now ?

In this 2 part series, I will try and explain the basic factors that determine the exchange rate between two currencies.

In the context of the exchange rate between USD and INR, we say that the INR is appreciating when less of INR buys the same amount of USD. Ex – When the exchange rates moved from 43.5 to 40.5 to 1 USD, we say that the INR is appreciating.

There are numerous factors that determine the exchange rates, and all are inter-related to the trading relationship between two countries. The following are some of the key factors that determine the exchange rate between two countries. Please note that no market is a free one i.e. there are factors that can override the factors given below and maintain an artificial rate. Ex – The Chinese government have a policy of deciding what the exchange rate between the Chinese Yuan and the US dollar should be and have been pretty much successful in maintaining that rate.

Differentials in interest rates: Higher interest rates in a country offer lenders a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. For example, if the rate of interest in the US was 3% but was 7% in India, many people will try to transferring funds in dollar based securities to those denominated in INR. When this happens, it would result in selling dollars on the foreign exchanges and buying INR, with the result that the demand for INR would rise and the supply of dollars would also rise. This would put pressure on the price of INR and push its value up against the dollar i.e leading to an appreciating INR.

As a rule of thumb we can conclude that
• A rise in the interest rate of a country will lead to a rise in the value of its currencies against other currencies (appreciation).
• A fall in the interest rate will lead to a fall in the value of fall in the value against other currencies (depreciation).
Other things being equal, an appreciation of the exchange rate will lead to:
• A rise in export prices from the country
• A fall in import prices to the country

This in turn would be expected to have an effect on the demand for both imports and exports. We should expect:
• The demand for exports to fall as export prices rise
• The demand for imports to rise as import prices fall

Differentials in inflation rate: As a rule of thumb, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners.

In the next part, we will see the other key factors that play a significant role in determining the exchange rate between two currencies