At present major currencies of the world are fluctuating. The rates of exchange between currencies are determined by the forces of demand for and supply of a currency in the foreign exchange markets and hence the rat€eof exchange.
1. International trade. Foreign exchange is required primarily for settlement of import and export transactions. In addition to this trade in goods, many invisible items also entail movement of foreign exchange, like rendering of services by residents of one country to that of another, in the form of transport, banking, technical services, etc. When the export of goods and services are increasing, it would mean the demand for the country’s currency would increase in the foreign exchange market because importers have to pay in that currency. The increase in demand would make the external value of the currency to rise.
Similarly, when imports increase the supply of the country’s currency in the foreign exchange market would increase. This will have the effect of fall in the external value of the currency.
2. Inflation. Inflation in the country would increase the domestic prices of the commodities. With the increase in price exports may dwindle because the price may not be competitive. With the decrease in exports the demand for the currency would also decline; this in turn would result in the decline of external value of the currency.
3. Interest rates. The interest rate has a great influence on short-term movement of capital. When the interest rate in a financial centre is higher than the rate prevailing in other centres, it attracts short-term funds from other centres. This would increase the demand for the currency of the centre and hence its value. The movement of huge surplus of OPEC countries from one centre to another to take advantage of interest differential is a good example.
4. Capital investments. The granting of foreign loan and international dealings in stock exchange would also influence the demand and supply in foreign exchange markets. The industrial climate in the country may be conducive for investors in other countries and induce them to invest in securities of the country. Or stock exchange transactions may be done for speculation. With good industrial climate and demand for securities the demand for the currency and its value would rise.
5. Political factors. Political stability induces confidence in the investors and encourages capital inflow into the country. This has the effect of strengthening the currency of the country. On the other hand, it makes the investors withdraw their investments. The outflow of capital from the country would weaken the currency. Any news about change in the government or political leader, or about policies of the government, would also have the same effect causing changes in the exchange rates.
6. Speculation. Speculation exerts powerful influence on the exchange rates, sometimes aggravating the trend set by other factors. A large-scale purchase or sale of foreign exchange by speculators with expectations of fall or rise in exchange rates further accentuates the fall or rise. The speculation may take the form of bull (purchasing heavily expecting a rise in price) or bear (selling heavily expecting a fall in price) campaigns. It may also take the form of leads and lags which means changing the time of settlement of debts with a view to get advantage of the change in exchange rates.