Factors That Determine a Currency’s Value Essay Sample

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Introduction of TOPIC

Increasing exchange rate fluctuations, such as those that have occurred in the US dollar, have recently revived the discussion about the causes of such movements and the criteria for calculating the long-term over- or undervaluation of a currency. Currency can be defined as any form of money that is in public circulation. Currency includes both coins and soft money paper money. Typically currencies are used as a medium of exchange for goods and services. The exchange rate indicates the price of a currency and plays therefore an important role.[1] Also when investing or purchasing in a foreign currency, it is important to understand the factors that determine a currency’s value. Investors are often exposed to different currencies, companies have overseas earnings, and many funds invest abroad. Exchange rate movements will therefore impact the returns of a business.[2] In the following this paper examines several factors that influence a currency’s value.

Factors that determine a currency’s value

1 Inflation

The first aspect that influences a currency’s value is the inflation. Inflation can be defined as the overall general upward price movement of goods and services in an economy.[3] Inflation is being measured by the inflation rate. The inflation rate is determined by the percentage rate of change in price level over time and can be defined as follows:

Inflation rate = [P(t)-P(t-1)] / P(t-1)*100%

A larger amount of currency in circulation can lower the value of that currency. That means if the supply of goods and services does not increase or not increases as much as the supply of money, the prices for goods and services will go up.[4] Also when referring to inflation, Purchasing Power Parity plays an important role. PPP is being defined as “An economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency’s purchasing power.”[5] PPP states that a nation’s currency and its general price levels are supposed to move in opposite directions.[6] If PPP holds and the differential inflation rates between countries are exactly offset by exchange rate changes, countries’ competitive positions in world export markets will not be systematically affected by exchange rate changes. If there are deviations from PPP, changes in nominal exchange rates cause changes in the real exchange rates which affect the international competitive positions of countries. Consequently this affects countries’ trade balances.[7]

The relative inflation rate affects international trade activity, which influences the demand and supply of foreign currencies. For example if U.S. inflation increases, there will be a higher U.S. demand for British goods and therefore demand for Pound. At the same time there will be a lower British desire for U.S. goods, and hence supply of Pound.[8]

In America a slow in inflation of foreign goods keeps prices of those goods stable. This allows American consumers to purchase the same amount or more of the same goods. As a consequence, the dollar may be weakened. Also the trade deficit can’t be closed. Moreover, news and expectations about possible inflations for instance of the dollar, cause reactions. The foreign exchange market may react preemptively and fluctuate the dollar. [9] To sum up, it can be said that the currency of a country with lower inflation than its trading partners should strengthen over time. Also it will maintain its “purchasing power” better than its peers. The yen has been the best performing major currency of the past 20 years. It is being said that the yen is being “overvalued”, but Japan’s consistently low inflation rate over this period could go some way to explaining its strength.[10]

2 Interests rates

Also interest rates influence the value of a currency. There exist two different types of interest rates- real and nominal interest rates. The nominal interest rate has no inflation factored in. The real interest rate can be described as:

Real Interest Rate= Nominal Rate – Rate of Inflation[11]

In general a higher interest rate means a higher demand for a currency. Foreign investors always look for the higher interest. Consequently the higher demand for a currency leads to an increase in its value. [12] Interest rate differentials in currencies lead to ‘carry trades’. Here, investors borrow the low interest rate currency and they then exchange it for a higher interest rate currency. The former currency weakens whereas the last currency will strengthen.[13]

In the following it will be analyzed how relative interest rates affect a currency’s value. Relative interest rate affects the international capital flow, which influences the demand and supply of foreign currencies and exchange rates. For example a higher U.S. interest rate leads to a lower U.S. demand for British bank deposits and hence leads to a lower demand for the other currency, in this case the Pound. However, it leads to a higher British desire for U.S. bank deposits and hence the supply of Pound.[14]

Furthermore, the currency’s value of one country is also being influenced by attractive interest rates in other countries. If the interest rates of the US for instance are rising or falling, the dollar’s value also depends on how US interest rates stack up to those of other countries. If the interest rates of the US for instance are lower, investors are likely to switch to different currencies that can offer a better return. If the US on the other hand has attractive interest rates, this will attract investors.

Also expectations about interest rates play an important role. The release of news may lead to a fluctuation of the dollar according to the coming inflow or outflow of investments that are expected to happen in the future.[15]

A parity condition which is often being encountered in literature is the Fisher Effect (FE) and the International Fisher Effect (IFE). The FE holds that “an increase (decrease) in the expected inflation rate in a country will cause a proportional increase (decrease) in the interest rate in the country: 1+i = (1+p)*(1+E(π))[16]

The IFE suggests that the nominal interest rate differential reflects the expected change in exchange rate, for example: E(e)= i$-i£
For instance if the interest rate is 6% per year in the US and 8% in the UK, the dollar is expected to appreciate against the British pound by about 2% per year.[17]

3 Trade and Investment

If someone wants to buy a country’s goods or invest in its stock market, the first step is to buy the country’s currency. Consequently exchange rates respond to trade and investment flows. One scenario is a country with improving economic prospects. This country is likely to attract capital from investors. A consequence is an increase in demand which should lead to a stronger currency.[18]

Balance of trade
The balance of trade is also known as the current account balance. The trade balance is equal to the difference between imports and exports. To apply this to an example, the US has been running a trade deficit[19] with the rest of the world for most of recent memory. The trade deficit is currently $2 billion a day and growing. Consequently the deficit is making foreign investors increasingly nervous and can affect the dollar significantly. The widening of the trade deficit in the U.S. within in the last years is represented in Figure 1.

Figure 1: US Trade Deficit (%GDP).[20]

Falling prices on foreign goods
A trade deficit is created by decreasing foreign prices for goods as those goods become more attractive to American consumers. On the other hand, if a natural price inflation or increased demand lead to a rise in prices of foreign goods more American goods might be consumed. This will help to narrow the trade deficit and it serves to help the dollar.

Balance of investment
When the US imports more than it exports, it means investors from other countries have to buy US assets to keep the dollar from falling. Simply stated, if the US imports more than it exports, foreign investors must buy dollar-denominated assets like bonds or treasury securities in order to offset the difference.[21]

4 Economy

1 Economic indicators

Other factors influencing a currency’s value are economic indicators. Those are reports which are being released by the government or a private organization and where a country’s economic performance is being rep

orted. Each of the indicators being publicized is very important. Changes in the conditions reported

will directly affect the price and volume of a country’s currency. It is important to understand the meaning of the numbers and their influence on the value of a currency.

Gross Domestic Product (GDP)
GDP represents the total market value of all goods and services produced in a country during a given year. Most traders focus on the advance and the preliminary report[22] as the GDP itself is often a lagging indicator. As it is a measure of growth, it is an important economic indicator which could affect a currency’s value. GDP growth rate:

GDP (t) = C(t) + I(t) + G(t) + NX[23]

Retail Sales
In the Retail Sales report the total receipts of all retail stores in a country are being measured. This report is a timely indicator of broad consumer spending patterns adjusted to seasonal variables. The performance of more important lagging indicators can be predicted and the economic situation of a country can be assessed.

Industrial Production
Industrial Production shows the change in production of factories, mines and utilities within a nation. Also the degree to which the capacity of each of these factories is being used is reported. The aim for a nation is to see an increase of production while the maximum capacity utilization is being used. If there are significant revisions between reports caused by weather changes for example, this can lead to volatility in the nation’s currency. Consumer Price Index (CPI)

The change of prices of consumer goods is being is being measured by the CPI. It helps to see if a country is making or losing money with its products or services.[24]

2 Economy and Economic Theory

Another decisive factor is the question whether or not an economy is in a growth or recession period. In growth periods there is an increase in a currency’s value, in recession a decrease. A higher demand raises the value and an increase in money supply can lead to a decrease of the value.[25] With every new dollar for instance which is being printed, each dollar is being valued less than before. This usually leads to inflation which directly eats into the value of the dollar.[26]

3 Industry

Industries like manufacturing and service industries are also important aspects of how a nation’s currency is valued. Strong growth in manufacturing sectors will make investors being more resolute, while a manufacturing slowdown will make them precautious.

Also, high employment rates lead to a stronger currency as a government is guaranteed more taxes to run efficiently.[27] To take as an example, American industry both affects and reacts to the value of the dollar. When the dollar falls, goods in America become cheaper and more attractive. However, when the value of the dollar is being increased, American industries have to compete harder against cheaper foreign labor and goods. Also an industry slowdown means a general slowing in the economy and can cause investors to become wary of the dollar. In contrast, a strong manufacturing growth can create a more attractive dollar. Furthermore, outsourcing creates a trade deficit. This causes US employment to suffer, which results in a decrease of the dollar. However, outsourcing also makes US companies more profitable and more attractive targets for foreign investment. Entrepreneurship creates attractive investment opportunities for foreign investors, supporting a stronger dollar. Finally higher or lower wages can either attract or scare off investors, creating a fluctuation in the dollar’s value.[28]

5 Government policy

Politics play an important part in a currency’s value. Budget deficits, geopolitical events, consumer tax cuts and entitlement programs determine the value. If a government has policies that weaken its economy or its control over the market, other countries will notice the changes. [29] Governments influence the equilibrium exchange rate by: • Intervening in the foreign exchange market

• Imposing foreign exchange barriers
• Imposing foreign trade barriers
• Influencing macros variables such as inflation, interest rates and income levels.[30] Government intervention takes place either in a direct or indirect way. A government will directly intervene in the foreign exchange market, if a central bank exchanges its currency hold as reserves for foreign currencies. This can be done in two different ways. For example, the US Federal Reserve can weaken (strengthen) the US dollar by buying (selling) foreign currency while selling (buying) US dollar. As the central banks do not adjust for the change in money supply, this process can be considered non-sterilized. If the Federal Bank, however, sells (to weaken US dollar) or buys (to strengthen US dollar) treasury securities to or from financial institution, it intervenes in a sterilized way because it engages in offsetting transactions to maintain the money supply. In contrast, indirect intervention means that central banks influence factors affecting the currency’s value such as interest rates or income levels as mentioned above.[31]

Furthermore, the government’s budget can affect the currency’s value. If a country is spending more money than it has available, foreign investors know that the country has to borrow from future generations and from the private sector. When the government keeps a good credit history, risk goes down and the value of the currency goes up. Terrorist attacks and war damage consumer and business confidence, economic growth is being hindered. Moreover it makes investors nervous because it will likely increase the national debt, and slightly increase the risk of default. Also geopolitical events play a role. The value of a currency will be negatively affected if a conflict or foreign involvement is being precipitated. Consistent policies lead to higher investments in that country. Demand is being increased and thus the value of the currency. As elections take place, the economy can be affected. Confidence or wariness can cause investors to flock to or flee from the dollar. Tax cuts for consumers increase spending, which can improve the economy of a country. This will be positive for a currency as long as it does not deepen the trade deficit or budget deficit. Increases in taxes however discourage consumer spending, but they help with government spending and debt. This can slow the economy, but at the same time lessen deficits of a country. [32]

6 Other factors influencing a currency’s value

Apart from the indicators mentioned, there are numerous other factors affecting a nation’s currency. Those factors will be presented in the following.

First of all, the weather can have an influence on a currency’s value. Weather affects agriculture, industry, energy consumption and local economies. For example unfavorable farming conditions can result in slow crops. As a result force grocers may to other countries to satisfy US agricultural needs. A trade deficit is being opened and the dollar weakened.Another reason for a change in currency’s value can be an unusually hot summer that can cause a rise in energy costs. Industries as well as consumer might be affected. As a result the Dollar may decrease because the currency will struggle as a lot of money has to be spent on relief and rebuilding.[33] Also printing a high amount of currency can decrease the value of the currency. In contrast, a small amount of currency in circulation can lead to an increase in the value of the currency.[34] In addition, a housing boom or bust can drop the value of homes. A slowing of the housing market means that if sellers’ asking prices will be less this will lead to a lower amount of consumer spending. This will result in lower demand for the currency. A growing, steady housing market builds the equity and net worth of home owners. Higher spending leads to growth of the economy which supports the dollar. An overinflated housing market will result in a fall of equity and personal wealth. It makes the dollar fall as well.[35]

Positive or Negative Perception of purchasers perceiving previous discussed parameters can influence the demand for a currency. When investors are optimistic about the global economy, money tends to flow into more “risky” assets, often denominated in higher interest rate and emerging market currencies. If concerns arise, money tends to flow more to assets that are being perceived as “safe havens”. Those are bonds issued by the US and Japanese governments. Therefore the dollar and yen tend to do well in times of turmoil.[36]

Conclusion

To conclude, it can be said that the foreign exchange market is enormous. It is being estimated that about US$4 trillion change hands daily, between central banks, retail and investment banks, institutional investors, companies, governments and retail investors. Therefore many business decisions are being made based on implicit or explicit forecasts of future exchange rates. Forecasting exchange rates as accurately as possible is important for currency traders and multinational corporations.[37] After analyzing the factors that determine a currency’s value, it can be concluded that a lot of differing factors play a role and have to be determined. Also Investors shouldn’t overlook the impact of currencies on their investments, and should view exchange rates as a risk as well as an opportunity. [38]

Reference List

Articlesbase: A List of Factors which determine Currency Value; October 9th, 2009. http://www.articlesbase.com/currency-trading-articles/a-list-of-factors-which-determine-currency-value-1321125.html (Retrieved on November 22nd 2011).

Cheol S. Eun, Bruce G. Resnick: International Financial Management; Fifth Edition. McGraw-Hill Irwin 2009.

Currency Trading: 50 Factors that Affect the Value of the US Dollar; August 8th, 2007. http://www.currencytrading.net/features/50-factors-that-affect-the-value-of-the-us-dollar/ (Retrieved on November 27th 2011).

Dr. Pinna: Trade Deficit widens 33%; February 12th, 2011. http://drpinna.com/wp-content/uploads/2011/02/trade-def-to-GDP.jpg (Retrieved on December 6th, 2011).

E How: Factors that Affect Currency Value; n.d. http://www.ehow.com/list_6298196_factors-affect-currency-value.html (Retrieved on November 27th 2011).

Finance Scholar: Real and Nominal Interest Rates; n.d. http://www.financescholar.com/real-nominal-interest-rates.html (Retrieved on December 5th 2011).

Fiance Yahoo: Fundamental Factors that Affect Currency Values; n.d.
http://finance.yahoo.com/education/currencies/article/106077/Basic_concepts_for_currencies_markets (Retrieved on November 26th 2011).

Investopedia: Purchasing Power Parity; n.d. http://www.investopedia.com/terms/p/ppp.asp#axzz1fG3jFW7J (Retrieved on November 22nd 2011).

Investorwords: Currency, n.d. http://www.investorwords.com/1240/currency.html (Retrieved on November 26th 2011).

Investorwords (2): Inflation, n.d.. http://www.investorwords.com/2452/inflation.html (Retrieved on November 26th 2011).

Hargreaves Lansdown: What determines a currency’s value; n.d. http://www.hl.co.uk/news/feature-articles/what-determines-a-currencys-value (Retrieved on November 29th 2011).

Lecture Notes: International Parity Conditions and Exchange Rate, Chapter 6. Slide 6, 9, 14-15, 33.

Gold Speculator: Spain: The hole in Europe’s Balance Sheet, August 31st, 2009. http://www.gold-speculator.com/outside-box/10015-spain-hole-europes-balance-sheet.html (Retrieved on December 6th 2011).

———————–
[1] http://www.investorwords.com/1240/currency.html
[2] Hargreaves Lansdown: What determines a currency’s value; November 2011. [3] http://www.investorwords.com/2452/inflation.html
[4] Lecture Notes: International Parity Conditions and Exchange Rate (Chapter 6 ,Slide 33).

[5] Investopedia: Purchasing Power Parity; November 22nd, 2011. [6] Currency Trading: 50 Factors that Affect the Value of the US Dollar; August 2007. [7]
Cheol S. Eun, Bruce G. Resnick: International Financial Management p.144. [8] Lecture Notes: International Parity Conditions and Exchange Rate (Chapter 6 ,Slide 6). [9] Currency Trading: 50 Factors that Affect the Value of the US Dollar; August 2007. [10] Hargreaves Lansdown: What determines a currency’s value; November 2011. [11] Finance Scholar: Real and Nominal Interest Rates; n.d.

[12] Articlesbase: A List of Factors which determine Currency Value; October 2009. [13] Hargreaves Lansdown: What determines a currency’s value; November 2011. [14] Cheol S. Eun, Bruce G. Resnick: International Financial Management. [15] Currency Trading: 50 Factors that Affect the Value of the US Dollar; August 2007. [16] i=nominal interest rate, p=real interest rate, E(À)= expected inflation rate. [17] Cheol S. Eun, Bruce G. Resnick: International Financial Management, p.149. [18] Hargreaves Lansdown: What dπ)= expected inflation rate. [19] Cheol S. Eun, Bruce G. Resnick: International Financial Management, p.149. [20] Hargreaves Lansdown: What determines a currency’s value; November 2011. [21] Trade deficit means that imports exceed exports.

[22] Dr Pinna: Trade Deficit widens 33%; February 2011.
[23] Currency Trading: 50 Factors that Affect the Value of the US Dollar; August 2007. [24] The advance and the preliminary report are being issued in the months before the final GDP figures. [25] C=Consumption, I=Investment, G=Government Spending and NX=Net Exports (Export-Import). [26] Finance Yahoo: Fundamental Factors that Affect Currency Values; November 26th 2011. [27] E How: Factors that Affect Currency Value; November 2011. [28] Currency Trading: 50 Factors that Affect the Value of the US Dollar; August 2007. [29] E How: Factors that Affect Currency Value; November 2011. [30] Currency Trading: 50 Factors that Affect the Value of the US Dollar; August 2007. [31] E How: Factors that Affect Currency Value; November 2011. [32] Lecture Notes: International Parity Conditions and Exchange Rate (Chapter 6 ,Slide 9). [33] Lecture Notes: International Parity Conditions and Exchange Rate (Chapter 6, Slide 14-15). [34] Currency Trading: 50 Factors that Affect the Value of the US Dollar; August 2007. [35] Currency Trading: 50 Factors that Affect the Value of the US Dollar; August 2007. [36] Articlesbase: A List of

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