Determinants of Currency Movements

Overview
Before we look at these forces, we should sketch out how exchange rate movements
affect a nation's trading relationships with other nations. A higher currency makes a
country's exports more expensive and imports cheaper in foreign markets; a lower
currency makes a country's exports cheaper and its imports more expensive in foreign
markets. A higher exchange rate can be expected to lower the country's balance of trade,
while a lower exchange rate would increase it.

Determinants of Exchange Rates

Numerous factors determine exchange rates, and all are related to the trading relationship
between two countries. Remember, exchange rates are relative, and are expressed as a
comparison of the currencies of two countries. The following are some of the principal
determinants of the exchange rate between two countries. Note that these factors are in no
particular order; like many aspects of economics, the relative importance of these factors
is subject to much debate.

1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising
currency value, as its purchasing power increases relative to other currencies. During the
last half of the twentieth century, the countries with low inflation included Japan,
Germany and Switzerland, while the U.S. and Canada achieved low inflation only later.
Those countries with higher inflation typically see depreciation in their currency in
relation to the currencies of their trading partners. This is also usually accompanied by
higher interest rates.

Factors of Inflation
Inflation is defined as the rate (%) at which the general price level of goods and services is
rising, causing purchasing power to fall. This is different from a rise and fall in the price of a
particular good or service. Individual prices rise and fall all the time in a market economy,
reflecting consumer choices or preferences and changing costs. So if the cost of one item, say a
particular model car, increases because demand for it is high, this is not considered inflation.
Inflation occurs when most prices are rising by some degree across the whole economy. This is
caused by four possible factors, each of which is related to basic economic principles of changes
in supply and demand:

1. Increase in the money supply.

2. Decrease in the demand for money.
3. Decrease in the aggregate supply of goods and services.
4. Increase in the aggregate demand for goods and services.
In this look concentrate specifically on the effects of aggregate supply and demand: cost-push
and demand-pull inflation

Cost-Push Inflation
Aggregate supply is the total volume of goods and services produced by an economy at a given
price level. When there is a decrease in the aggregate supply of goods and services stemming
from an increase in the cost of production, we have cost-push inflation. Cost-push inflation
basically means that prices have been “pushed up” by increases in costs of any of the four factors
of production (labor, capital, land or entrepreneurship) when companies are already running at
full production capacity. With higher production costs and productivity maximized, companies
cannot maintain profit margins by producing the same amounts of goods and services. As a
result, the increased costs are passed on to consumers, causing a rise in the general price level
(inflation).

Conclusion
Inflation is not simply a matter of rising prices. There are endemic and perhaps diverse reasons at
the root of inflation. Cost-push inflation is a result of decreased aggregate supply as well as
increased costs of production, itself a result of different factors. The increase in aggregate supply
causing demand-pull inflation can be the result of many factors, including increases in
government spending and depreciation of the local exchange rate. If an economy identifies what
type of inflation is occurring (cost-push or demand-pull), then the economy may be better able to
rectify (if necessary) rising prices and the loss of purchasing power.
 2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By manipulating
interest rates, central banks exert influence over both inflation and exchange rates, and
changing interest rates impact inflation and currency values. Higher interest rates offer
lenders in an economy a higher return relative to other countries. Therefore, higher
interest rates attract foreign capital and cause the exchange rate to rise. The impact of
higher interest rates is mitigated, however, if inflation in the country is much higher than
in others, or if additional factors serve to drive the currency down. The opposite
relationship exists for decreasing interest rates - that is, lower interest rates tend to
decrease exchange rates.

Fiscal policy is the means by which a government adjusts its levels of spending in order to
monitor and influence a nation's economy. It is the sister strategy to monetary policy with which
a central bank influences a nation's money supply. These two policies are used in various
combinations in an effort to direct a country's economic goals. Here we take a look at how fiscal
policy works, how it must be monitored and how its implementation may affect different people
in an economy.

Indian Currency Movememts

How Fiscal Policy Works

Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known
as Keynesian economics, this theory basically states that governments can
influence macroeconomic productivity levels by increasing or decreasing tax levels and public
spending. This influence, in turn, curbs inflation (generally considered to be healthy when at a
level between 2-3%), increases employment and maintains a healthy value of money
Balancing Act
The idea, however, is to find a balance in exercising these influences. For example, stimulating a
stagnant economy runs the risk of rising inflation. This is because an increase in the supply of
money followed by an increase in consumer demand can result in a decrease in the value of
money - meaning that it will take more money to buy something that has not changed in value.

Let's say that an economy has slowed down. Unemployment levels are up, consumer spending is
down and businesses are not making any money. A government thus decides to fuel the
economy's engine by decreasing taxation, giving consumers more spending money while
increasing government spending in the form of buying services from the market.

CURRENT ACCOUNT DEFICIT

The current account is one of the two primary components of the balance of payments,
the other being the capital account. The current account is the sum of the balance of trade
(exports minus imports of goods and services), net factor income (such as interest and dividends)
and net transfer payments (such as foreign aid). The current account balance is one of two major
measures of the nature of a country's foreign trade (the other being the net capital outflow). A
current account surplus increases a country's net foreign assets by the corresponding amount, and
a current account deficit does the reverse.

A current account deficit occurs when a country's total imports of goods, services and
transfers is greater than the country's total export of goods, services and transfers. This situation
makes a country a net debtor to the rest of the world. A substantial current account deficit is not
necessarily a bad thing for certain countries. Developing counties may run a current account
deficit in the short term to increase local productivity and exports in the future.

How it affects the currency movements?

A deficit in the current account shows the country is spending more on foreign trade than
it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other
words, the country requires more foreign currency than it receives through sales of exports, and
it supplies more of its own currency than foreigners demand for its products. The excess demand
for foreign currency lowers the country's exchange rate until domestic goods and services are
cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic
interests.

There are two types of exchange rate systems.

• Fixed Exchange Rate Countries - Under a fixed exchange rate system, the government
bears the responsibility to ensure that there are no surpluses and deficits. It tries to
 maintain the balance of payments at zero level. In this system the current account deficit
does not affect the exchange rates.

• Floating Exchange Rate Countries - Under a floating exchange rate system, the exchange
rate is determined by the market forces. Surpluses or deficits in the current account
influence exchange rate in this kind of system.

The currency movements are affected when there is a current account deficit in the home
country. The home currency depreciates. When there is current account deficit in the foreign
currency, the exchange rate of the home currency is also affected by that.

The current account deficit also gets off set by a surplus in the capital account as the whole
balance of payments affects the currency movements. When there is a capital account surplus, it
means that more and more investment is coming into the country. So, there is a increase in the
demand of the home currency, thus appreciating the currency. Thus, the whole effect comes to a
very low movement in the currency.

Current Account Deficit & the Rupee Movement

After a gap of 20 years, India’s current account deficit as a percentage of gross domestic
product (GDP) is expected to touch 3% this fiscal. The current account deficit increased over the
last five quarters to touch $13.7 billion (Rs.60,800.6 crore) in the April-June quarter of 2010-11.
Anecdotal evidence indicates the deficit increased the next quarter too though data for the period
has not yet been released. The gap was 2.9% of GDP last fiscal year.

Despite being a 3%
of GDP deficit there
is a sharp
appreciation of the
rupee. The rupee is
gaining
continuously even
when there is a
huge current
account deficit.
Over the last nine
weeks, the rupee
has appreciated by
around 3% against
the US dollar to
around Rs.44.19. The appreciation of the rupee can be seen through the following chart:
 Normally, when a country runs a moderately high current account deficit and relatively
rapid inflation is weakening its competitiveness, one expects to see a depreciation of its currency
to bring about an adjustment in imbalances. The fact of a major currency appreciation over the
past half year is indubitable and worrisome against the background of a sizable current account
deficit.

The reasons for such an appreciation are many. Firstly, the RBI is following a non-
interventionist approach to currency management. Thus, RBI is refraining from any active
intervention in the currency market to bring rupee down. Secondly, FIIs have made a record
investment of USD 19.43 billion (Rs 89,116 crore) in local equities so far this year. Thus, there
is a surplus in the capital account of the country. This is off setting the current account deficit of
the country. Thirdly, the dollar is weakening against major currencies in the world which is also
affecting the exchange rate of the rupee causing it to appreciate. Thus, all these reasons are
making the rupee to appreciate despite being a huge current account deficit of the country.

PUBLIC DEBT

Public debt is also sometimes referred to as government debt. It is a term for all of the
money owed at any given time by any branch of the government. It encompasses public debt
owed by the federal government, the state government, and even the municipal and local
government.

Public debt is, in effect, an extension of personal debt, since individuals make up the
revenue stream of the government. Public debt accrues over time when the government spends
more money than it collects in taxation. As a government engages in more deficit spending, the
amount of public debt increases.

How it affects the currency movements?

A large debt encourages inflation, and if inflation is high, the debt will be serviced and
ultimately paid off with cheaper real currency in future. In the worst case scenario, a government
may print money to pay part of a large debt, but increasing the money supply inevitably causes
inflation. Moreover, if a government is not able to service its deficit through domestic means
(selling domestic bonds, increasing the money supply), then it must increase the supply of
securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove
worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners
will be less willing to own securities denominated in that currency if the risk of default is great.
For this reason, the country's debt rating is a crucial determinant of its exchange rate.

The fall of the Euro during the Debt Crisis

The European debt crisis which started with the Greek debt crisis and also affected
Portugal & Spain had a depreciating effect on the Euro. Concerns of the debt crisis in the region
was threatening the outlook and caused pessimism across global markets which led to huge
selloff across equity, commodity and currency markets.

This led to a great fall in the

Euro which is the common
currency for the 16 nations of
the European Union. The
euro hit a low of 1.1942
versus the dollar this week as
the European debt crisis
continued to haunt the single
currency. As it is the single
currency there were also fear
that whether the Eurozone
will be able to contain this
crisis or whether it is a fall of
the euro.

However, with many measures taken by the euro zone countries, Euro again gained and
reached to 1.4 levels. Thus, public debt can also play a major role in the movements of the
currency.

Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with strong economic performance in
which to invest their capital. A country with such positive attributes will draw investment funds
away from other countries perceived to have more political and economic risk. Political turmoil,
for example, can cause a loss of confidence in a currency and a movement of capital to the
currencies of more stable countries.

TERMS OF TRADE

The Terms of Trade is the average price of exports / by the average price of imports. It is a
measure of a countries relative competitiveness.

• If export prices rise relative to import prices we say there has been an improvement in the
terms of trade. – A unit of export buys relatively more imports.
• If import prices rise relative to export prices we say there has been deterioration in the
terms of trade.
Terms of trade are defined as the ratio of the price of a country’s exports to the world price of
imports. In other words, they are defined as the price of exportable in terms of importable. Thus,
the effect of the terms of trade on the real exchange rate operates through import and export price
variations.

The impact of a change in the terms of trade on the real exchange rate is theoretically ambiguous.
It depends on the relative strength of the income and substitution effects, which emerge from
changes in the prices of both imports and exports. If the direct income effect dominates the
indirect substitution effect following an increase in the price of exports relative to imports (an
improvement in the terms of trade), the real exchange rate will appreciate.

This is because when the price of Country’s exports increases, the income of the country
increases and, in turn, raises the demand for non tradable goods and hence a real exchange rate
appreciation. On the other hand, the indirect substitution effect may dominate the direct income
effect leading to opposite terms of trade effect; an improvement in the terms of trade

may lead to a depreciation in the real exchange rate. Thus, a fall/rise in the terms of trade tends
to stimulate a depreciation/appreciation of the real exchange rate when the income effect is
stronger than the substitution effect. The opposite is true when the substitution effect dominates
the income effect.

A ratio comparing export prices to import prices, the terms of trade is related to current accounts
and the balance of payments.

If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade
have favorably improved. Increasing terms of trade shows greater demand for the country's
exports. This, in turn, results in rising revenues from exports, which provides increased demand
for the country's currency (and an increase in the currency's value). If the price of exports rises
by a smaller rate than that of its imports, the currency's value will decrease in relation to its
trading partners.

Determinants of Real Exchange Rate in India ( Reserve Bank of India)

Terms of trade (ToT) affect the real exchange rate through income effect and substitution affect
and net affect depends on the relative strength of these affects as both effects work in reverse
direction to each other. Theoretical models although provide the importance of ToT disturbances
as potential source of real exchange rate fluctuations, their impact on the real exchange rate
remains undefined. On the one hand, deterioration in ToT generates negative income effect
through decline in the domestic purchasing power and adversely affects the private demand for
non-traded goods and leads to decline in prices eventually resulting into real depreciation of the
exchange rate. On the other hand, weakening ToT induces substitution effect and makes the
consumption of imported goods more expensive. The substitution effect result into shift of
demand in favour of non-traded goods increasing their prices and real appreciation in exchange
rate. As mentioned above, the total effect of a ToT worsening on real exchange rate would
depend on the strength of the income and substitution effects. However, recent empirical studies
have found that the income effect is predominant; hence, ToT improvements are associated with
real appreciation in the long-run.