In a free market, it is the demand and supply of the currency which should determine the exchange rates but demand and supply is the dependent on many factors, which are ultimately the cause of the exchange rate fluctuation, some times wild.
The volatility of exchange rates cannot be traced to the singe reason and consequently, it becomes difficult to precisely define the factors that affect exchange rates. How ever, the more important among them are as follows:
Political Factors
The political factors influencing exchange rates include the established monetary policy along with government action or inaction on items such as the money supply, inflation, taxes, and deficit financing. Active government intervention or manipulations, such as central bank activity in the foreign currency markets, also have an impact. Other political factors influencing exchange rates include the political stability of a country and its relative economic exposure (the perceived need for certain levels and types of imports). Finally, there is also the influence of the International Monetary Fund.
Economic Factors
Economic factors affecting exchange rates include hedging activities, interest rates, inflationary pressures, trade imbalances, and Euromarket activities. Irving Fisher, an American economist, developed a theory relating exchange rates to interest rates. This proposition, known as the Fisher Effect, states that interest rate differentials tend to reflect exchange rate expectations.
On the other hand, the purchasing-power-parity theory relates exchange rates to inflationary pressures. In its absolute version, this theory states that the equilibrium exchange rate equals the ratio of domestic to foreign prices. The relative version of the theory relates changes in the exchange rate to changes in price ratios.
Other economic factors influencing exchange rates are included in a theory proposed by Dombush, who presented both a long-run view and a short-run view of exchange rate determinants. According to Dombush, the long-run determinants of exchange rates are the nominal quantities of monies, the real money demands and the relative price structure. Among the factors that exert an influence on real money demand are interest rates, expected inflation, and real income growth. In the short run, Dombush theorizes, exchange rates are determined by interest arbitrage together with speculation about future spot rates.
Psychological Factors
Psychological factors also influence exchange rates. These factors include market anticipation, speculative pressures, and future expectations.
A few financial experts are of the opinion that in today’s environment, the only ‘trustworthy’ method of predicting exchange rates is by gut feel. Bob Eveling, vice-president of financial markets at SG, is Corporate Finance's top foreign exchange forecaster for 1999. Eveling's gut feeling has, defied convention, and his method proved uncannily accurate in foreign exchange forecasting in 1998.
SG ended the Corporate Finance forecasting year with a 2.66% error overall, the most accurate among 19 banks. The secret to Eveling's intuition on any currency is keeping abreast of world events. Any event, from a declaration of war to a fainting political leader, can take its toll on a currency's value. Today, instead of formal models, most forecasters rely on an amalgam that is part economic fundamentals, part model and part judgment.
The volatility of exchange rates cannot be traced to the singe reason and consequently, it becomes difficult to precisely define the factors that affect exchange rates. How ever, the more important among them are as follows:
Political Factors
The political factors influencing exchange rates include the established monetary policy along with government action or inaction on items such as the money supply, inflation, taxes, and deficit financing. Active government intervention or manipulations, such as central bank activity in the foreign currency markets, also have an impact. Other political factors influencing exchange rates include the political stability of a country and its relative economic exposure (the perceived need for certain levels and types of imports). Finally, there is also the influence of the International Monetary Fund.
Economic Factors
Economic factors affecting exchange rates include hedging activities, interest rates, inflationary pressures, trade imbalances, and Euromarket activities. Irving Fisher, an American economist, developed a theory relating exchange rates to interest rates. This proposition, known as the Fisher Effect, states that interest rate differentials tend to reflect exchange rate expectations.
On the other hand, the purchasing-power-parity theory relates exchange rates to inflationary pressures. In its absolute version, this theory states that the equilibrium exchange rate equals the ratio of domestic to foreign prices. The relative version of the theory relates changes in the exchange rate to changes in price ratios.
Other economic factors influencing exchange rates are included in a theory proposed by Dombush, who presented both a long-run view and a short-run view of exchange rate determinants. According to Dombush, the long-run determinants of exchange rates are the nominal quantities of monies, the real money demands and the relative price structure. Among the factors that exert an influence on real money demand are interest rates, expected inflation, and real income growth. In the short run, Dombush theorizes, exchange rates are determined by interest arbitrage together with speculation about future spot rates.
Psychological Factors
Psychological factors also influence exchange rates. These factors include market anticipation, speculative pressures, and future expectations.
A few financial experts are of the opinion that in today’s environment, the only ‘trustworthy’ method of predicting exchange rates is by gut feel. Bob Eveling, vice-president of financial markets at SG, is Corporate Finance's top foreign exchange forecaster for 1999. Eveling's gut feeling has, defied convention, and his method proved uncannily accurate in foreign exchange forecasting in 1998.
SG ended the Corporate Finance forecasting year with a 2.66% error overall, the most accurate among 19 banks. The secret to Eveling's intuition on any currency is keeping abreast of world events. Any event, from a declaration of war to a fainting political leader, can take its toll on a currency's value. Today, instead of formal models, most forecasters rely on an amalgam that is part economic fundamentals, part model and part judgment.