Exchange Rate / causes of fluctuations in the Rate of Exchange
Exchange Rate
The international monetary aspect refers to the monetary transactions between the nations and to how the price of currency of a country is determined in terms of another currency in the international financial market. The rate at which the currency of one country is exchanged for the currency of another country is called the exchange rate. By definition, the exchange rate is the rate at which currency of one country is bought and sold.
Causes of Fluctuation in Exchange Rate
The foreign exchange market conditions are not static. They are subject to change due to changing domestic and external economics conditions. Therefore, market determined exchange rate is subject to frequent variations due to the following factors:
1. Change in Domestic Prices: A change in domestic prices, foreign prices remaining constant, changes the demand and supply conditions of foreign exchange. For example, a rise in domestic prices in India, all other things remaining the same, reduces foreign demand for Indian goods and increases India’s demand for foreign goods. Consequently, India’s imports increase causing an increase in demand for foreign exchange and an upward shift in the India’s demand curve. For the same reason, India’s exports decrease causing a leftward shift in her foreign exchange supply curve. Both these changes cause a change in the exchange rate.
2. Change in the Real Income: A change in real income of a country, other factors remaining the same, increases its demand for both domestic and foreign goods. Demand for foreign goods increases because, in general, imports are income elastic. Increase in imports increases demand for foreign exchange and, therefore, the exchange rate rises. For example, if real income of India increases, ceteris paribus, her imports increase because they are income-elastic. Increase in imports increases India’s demand for foreign exchange. This makes the demand curve shift upward causing a rise in the exchange rate. Similarly, when real income of foreign countries increases, ceteris paribus, it results in appreciation of Indian currency.
3. Change in the Rate of Interest: Change in the interest rate in different countries affects the capital flows between the nations and the demand and supply conditions. Capital tends to flow from low-interest-rate countries to the high-interest-rate countries. The change in the pattern of capital flow leads to a change in demand and supply conditions for foreign exchange which changes the exchange rate.
4. Structural Change: The structural change in an economy, for example, change in the composition of GNP and technological and industrial innovations, change the cost structure of a country which in its turn changes the relative price structure. Such changes cause a change in the demand and supply conditions and hence a change in the exchange rate.
5. Speculative Demand and Supply: The speculative demand for and supply of foreign exchange too change the position of the demand and supply curves and therefore the exchange rate also changes.
The factors noted above keep exchange rate floating. Such an exchange rate is called floating exchange rate. Whether exchange rate remains stable over a period of time depends on the market conditions.
