A country cannot have all the resources or materials needed for economic growth that is why countries outsource into other countries for these resources, so as to be productive and efficient as these resources are cheaper in the other country hence the need for international trade. Currencies differ as countries differ so as the economic growth therefore making the value of currencies different from one another. Some countries have high currency value in relation to others, therefore before trading internationally, there is a need to determine current value of the foreign currency so as to derive an equivalent to your own currency, this can only be determined by knowing the current currency rate of the foreign currency in relation to your own currency hence the need for exchange rate. “Exchange rate”; is the value of a currency used to convert into another currency. Exchange rate is a normal phenomenon for international traders. Exchange rate isn’t constant as there are factors that affect the rate of a currency to either appreciate (increase in value) or depreciate (decrease in value). This report would discuss some of these factors and relate them with examples; also it will show how to develop an overall forecast of currency movement.
QUESTION 1- FACTORS THAT INFLUENCE EXCHANGE RATE
There are several factors that affect exchange rate; five of these factors would be critically evaluated. They are;
A) Relative inflation rate: Inflation is a continuous increase in the general price level in an economy over a period of time. If there is high inflation in a country the products will not be affordable therefore allowing consumers to purchase product from a country where there is low rising inflation rate, in other words the country with high inflation rate tend to demand for the currency of the low rising inflation rate so as to purchase their goods. This would cause an increase in the currency that is in demand and in relation reduce the value of the other currency. Factors that can cause inflation are demand pull; where an economy is close to full employment rate, there would be an increase in aggregate demand which leads to an increase in the price level. Another factor is cost push; when there is an increase in cost of firm, the firm will increase the prices of end product by reducing aggregate supply of product in the market hence inflating prices of available end product. If a country has a low inflation rate over another, the currency value tend to appreciate and a country with higher inflation rate depreciate in currency value , which goes along with higher interest rates.
For example; if the U.S economy is having general rapid increase in prices of goods and services this means their economy is experiencing high inflation, and in Europe, the prices of goods and services increase at a slower rate where the inflation is low. These price disparity makes European goods cheaper and much more attractive to U.S businesses and consumer, and on contrary, make U.S goods more expensive and in this way less attractive to European companies and consumers. This simply means, the more the demand for European goods, the more demand for European currency and the more demand on a currency makes the currency gain value.
Exhibit 1.1 shows a shift in the demand curve reflecting the increased demand from the US to purchase European goods and thus demand more Euros. This increase in demand due to differences in inflation rates brings a new equilibrium point that reflects a higher price (exchange rate) in dollar/euro.
Exhibition 1.1 equilibrium points for exchange rates with rising US inflation.
B) Relative interest rate: Interest rate is the cost you pay for borrowing money or the income gained from lending money. Interest rate influences the demand and supply of currency. A situation where a country’s interest rate is high tends to attract investors as they would receive a high rate of return. The higher the interest rate of a country, the more the foreign investment, the more the demand of a currency and this leads to rise in exchange rate. If a company, for example a U.S company issue bond (Bond is a debt security, purchased in order to lend money to a company or government) of 7%, it means they would pay 7% interest to those who purchase the bond , meanwhile European companies offer to pay 3% for their bond issues, this means that U.S bond are more attractive because the return is higher, in that case people in Europe would rather invest their money in U.S companies than in their home country, this will simply bring increase in the demand for U.S dollar and thus rise in exchange rate, therefore the U.S dollar will appreciate in relation to euro.
As shown in Exhibit 1.2; when investors seek fewer Euros to invest in Europe, the demand for euro drops. Also, in this example because European investors exchange euro for dollar to take advantage of the higher U.S interest rate , the supply of Euros increase and the supply curve shifts to the right (more euro available) while the demand curve shifts to the left (fewer euro are sought by investors). This position reduces or depreciates the value of the euro relative to the dollar.
Exhibit 1.2 Equilibrium points for exchange rates with rising US interest rate.
An increasing interest rate often follows an increasing inflation rate; the effect on the value of a currency can be offset. Increasing inflation, increases prices and reduces the demand for a currency; increasing interest rate attracts investors and increase the demand for a currency. To examine these effects in combination, financial experts often look at the “Real interest rate” (Real interest rate is the rate of interest investors anticipate to receive after allowing for inflation). It is sometimes called the ‘Fisher effect’. It is represented as;
Real interest rate = interest rate – inflation rate
Therefore relative inflation rate correlates with relative interest rate.
C) Relative income level: Income is the money a person or business receives in exchange for providing either a good or service, income can also be received through investing capital. It is the company’s remaining revenue after all expenses and taxes have been paid. Income level is a factor that affect exchange rate, in the sense that a country having a high income level, take for example U.k and Germany; if the income level in U.K is high, they would import more automobile from Germany regardless of the price, in that case making the price of the euro to rise. Another scenario is France and China. China imports planes from France, if the income level of china should increase, they would import more planes from France, in that case demanding for more euro, like all other factors that can increase the demand for currency, this would make the price of the European euro rise. This simply means that the more the demand to export planes to china the more likely increase in the price of planes, making the price of euro to rise as well.
D) Government controls: A Government control is another factor that influences exchange rate. It is the interference of the government on the level of importation or investments from foreign country, whereby the government place barriers on foreign trade and investment , imposing quotas, tariffs or restrictions on import, so as to offset the demand for foreign currencies. For example, if investors wish to buy bonds in the U.K because the interest rate is better than in the U.S, this would increase the demand for pound, and in turn, the dollar will decrease requiring more dollar to buy pound. If the U.S government taxes the returns on U.K bonds at a higher rate than the U.S bonds, the demand for pounds will drop, so is the exchange rate. Another example, if consumers in France are importing goods from U.S because of high inflation rate in France, the government can impose tariff on importation from the U.S so as to offset the depreciation of the currency.
Governments often buy and sell currencies in the exchange market for single purpose of influencing supply and demand and thence the exchange rates. “For example during the September 2000, several central banks, including the U.S Federal Reserve and the European central bank (the central bank of the EU) bought about 4 billion U.S dollar worth of euro to strengthen the euro” (Cullen and Parboteeah, 2009).
Another example; china in 2011(Beijing) imposed additional duties on cars imported from the United States.” These high imports of American made cars was disturbing the growing economy of china, thereby the Chinese government imposed extra duties on the importation of highly demanded American cars so as to stabilise and strengthen its currency and raise patronage of locally made cars” (Guardian.com, 2011)
E) Balance of payment: “Balance of payment is a statistical record of all the economic transactions between residents of the reporting country and residents of the rest of the world, during a given period of time”. (Pilbeam 2013)
The balance of payment often reflects in the country’s current account, and it includes all the balance of trade (difference in the value of exports and imports of visible items) and also earnings on foreign investments. It shows all the amount of goods and services a country has been exporting and importing, also the amount that has been borrowed or lent. Balance of payment is a factor that affects exchange rate in the sense that; if a country’s balance of payment shows that the export prices increased at a greater rate than its imports prices; this will result in higher revenue, which causes a higher demand for the country’s currency and an increase in its currency’s value. And when there is an increase in currency value, it will result in an appreciation of exchange rate. For example, if the current account of UK shows that foreign investment from the US into their country was higher than their investment in the US due to the high interest rate offered by the UK which attracted the foreign investors, the balance of payment is likely to show higher revenue gained in UK in relation to the US.
QUESTION 2
I) U.K inflation has suddenly increased substantially, while country K’s inflation remains low;
As explained in question 1 that inflation is the general increase in the prices of goods and services; if the u.k inflation has suddenly increased, this means that the prices of goods and services has gone high making their products expensive and therefore consumers might not be able to afford them. In relation to country k’s inflation which remains low, means country k’s goods and services still remains the same or might be cheaper compared to u.k. In other words u.k consumers would find it better to import from country k, therefore increasing the export level in country k. This means u.k consumers would have an increased demand for krank, and since country k would not be importing from the u.k in the meantime, there would be a decreased supply of krank for sale. In relation to the explanation of ‘relative inflation rate’ in question 1; when there is an increase in demand for currency, the value of the currency appreciates, and when there is a decrease in demand of currency the value depreciate. In other words the value of the krank will appreciate in relation to the u.k pound.
ii) U.K interest rates have increased substantially, while country k’s interest rate remains low;
U.K interest rate will increase due to the increase in inflation rate; as mentioned earlier ‘an increase in inflation rate brings an increase in high interest rate’. The increase in interest rate is probably because u.k firms had an increase in cost of production, hence the need to sell bonds so as to raise money in the firms. In order to attract country k’s investors, they need to offer a higher interest rate in relation to the interest rate of country k. Therefore since country k’s interest rate remains low, investors from country k would definitely be more attracted to u.k’s bond offer as the return on investment would be high in relation to country k. In that case the investors in country k would have an increased demand for pound, also the u.k investors would rather invest in their home country rather than in country k, and thus, u.k decrease in the demand for krank. In relation to the explanation of relative interest rate in question 1, country k would have an increased demand for pound and u.k would have a decreased demand for krank therefore the value of pound would appreciate in relation to the krank.
iii) The UK income level increased substantially, while country k’s income level has remained unchanged.
If the UK income level increased substantially, this is due to the increased capital investment from country k into the u.k firms which was as a result of proposed high interest rate which attracted country k’s investors into investing in u.k firms. The increased income level in the u.k means the u.k consumers would have more money to import from country k, and since the income level in country k remains unchanged, the importing rate ratio remains the same, in other words u.k importing rate ratio would supersede that of country k because of the increased income level in the UK. Therefore the export from country k to UK would be higher than import from UK into country k. In relation to the explanation of relative income level in question 1; the UK consumers would have an increased demand for the krank, therefore the value of krank would appreciate in relation to pound, thus a rise in exchange rate of krank’s currency.
iv) UK is expected to impose a small tariff on goods imported from country k.
The increased income level in the UK which leads to a high increase in importation from country k will put a downward pressure on the pound, and this would affect the exchange rate value as the pound value will depreciate over the krank. In order for the UK government to offset the depreciation in the value of pound, they would have to interfere by imposing a tariff on goods imported from country k. This tariff imposed on country k’s goods would decrease the UK importation from country k, as they would rather buy their products from their home country because the good from country k would no longer be desirable. In this case, there would be a UK decreased demand for krank, and when there is a decreased in demand for krank currency; the value of krank will depreciate in relation to pound.
QUESTION 3
Overall forecast of the movement of krank against the pound;
As an international cash manager, to be able to give a forecast on the movement of krank against pound, I did a research and based on my research in relation to the above scenario of uk and country k, ‘relative economic strength’ is the approached that would be used to determine an overall forecast of the value of krank movement against pound.
One of the major factor that would determine economic strength is ‘foreign investment’ and looking at the above scenarios, country k had two currency appreciation, one was as a result of high inflation rate in the u.k, which increased the u.k demand for krank due to the increase in importation of goods from country k into the u.k, and thus gave a rise in country k’s currency value. The second scenario was the increase in income level in the u.k, which also increased the importation level of country k’s goods into the u.k, therefore increasing the demand for krank and thus appreciation in krank’s currency value. All of country k’s increase in currency value was based on trade flows, and looking at the factors that affect exchange rate, relative inflation rate, relative interest rate and relative income level are major factors that can affect exchange rate. While terms of trade, is a minor factor. Looking at the u.k scenarios on the order hand, the factor that gave an increase in the pound value was interest rate (which is one of the major factor that affect exchange rate) the high interest rate in the u.k attracted foreign investors (country k’s investors) to invest in the economy of u.k, and thus, brings an increase in capital investment in the u.k; when there is an increase in capital investment, there would be an increase in income level (which is another major factor that determines exchange rate). High interest rate brings about high capital inflow, and capital inflow subdues trade flows, also capital inflow is a factor that increases the growth or strength of the economy in a country. In conclusion, based on the forecast approach adopted and all the scenarios given above, the overall forecast of the krank movement against pound will depreciate in relation to pound value and thus, a decrease in exchange rate of the krank in relation to pound.
.