The following points highlight the four main factors affecting the exchange rate. The factors are: 1. Differing Rates of Inflation 2. Capital Movements 3. Structural Changes 4. Role of Speculation.
Factor # 1. Differing Rates of Inflation:
True enough, the exchange rates of countries that inflate fastest will be depreciating, while the exchange rates of countries that inflate slowest will be appreciating. Changes in relative price levels and exchange rates can exactly offset each other, leaving relative international competitive position unchanged. This is the essence of purchasing power parity theory.
The logic is simple. With all wages and prices exactly doubled in India (and money supply doubled to finance them), India can buy exactly the same volume of imports and sell exactly the same volume of exports at the new exchange rate that has doubled like everything else. (It is as if each old rupee were now equal to two new rupees.)
In the language of Samuelson, “Under floating exchange rates, in the longest run it is the monetary policies of the different countries that ultimately determine their price levels and thereby strongly influence the trends of their exchange rates.”
Factor # 2. Capital Movements:
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Exchange rates are also affected by major capital flows. The currencies of capital-importing countries usually appreciate and capital-exporting countries experience depreciation of their currencies.
Suppose American savers wish to buy British assets and thus invest much of their savings in Britain. An increased desire to invest in the UK will lead to an increase demand for sterling. The demand curve for sterling will shift to the right. Consequently, the sterling will appreciate in value and the dollar will depreciate.
Factor # 3. Structural Changes:
In a dynamic world structural changes like changes in cost structures, or the invention of new products or any such factor that affects the pattern of comparative advantage, may and often do affect the exchange rate.
As R.G. Lipsey says, “a country might be less dynamic than its competitors, so that at the initial set of prices consumers’ demand shifts slowly away from the home country products towards those of foreign countries. This would cause a slow but steady depreciation in the above country’s exchange rate.”
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Big changes like oil price like may also have like effects. Similarly the development of oil substitutes may also cause major changes in equilibrium exchange rates.
Factor # 4. Role of Speculation:
It may also be noted that exchange rate changes are often caused by the actions of the speculators. If they expect the price of dollar to go up in terms of sterling they will buy dollar by selling sterling. The supply of sterling will go up and the supply of dollar will fall in the foreign exchange market. So dollar will appreciate and sterling will depreciate.
In fact, the debate over fixed and floating exchange rates revolves around the role of speculators. As in stock exchanges and commodities markets, speculators tend to take a very short view and reinforce price movements in a destabilising manner rather than counteract them.