Factors Influencing Foreign Exchange Rate Fluctuations

The foreign exchange market is influenced by various factors including supply and demand for commodities, inflation rates, political and economic stability, and government debt. Fluctuations in these elements lead to changes in foreign exchange rates. Governments intervene in this market with the objective of improving their nation's economic health through measures such as stabilizing exchange rates, repaying foreign loans, and enhancing balance of payments. These interventions are crucial for preventing the undervaluation or overvaluation of national currencies, ensuring essential imports, supporting domestic industries, and managing conspicuous consumption. Through strategic use of reserves, adjusting interest rates, borrowing from foreign entities, and implementing fiscal or monetary policies to curb inflation, governments aim to correct market failures, reverse trade deficits, and boost overall economic performance.

Running head: INTERNATIONAL FINANCE
INTERNATIONAL FINANCE
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Table of contents
Introduction.................................................................................................................................................3
Discussion....................................................................................................................................................3
Conclusion...................................................................................................................................................7
References...................................................................................................................................................8

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Introduction
The objective of this report is to provide an overview on the main factors affecting
relative prices of commodities. Fluctuations in prices are upward or downward swings in
commodity prices in the economy. A significant part of the price differences between the
countries are the terms of trade of goods and services, fluctuations in exchange rate, wage
compression etc. The causes of price fluctuations between the nations focus on the factors that
impact the prices of tradable products, mainly services, as the price divergence apt to be
eroded in the traded industry of the nation (Frank, Bernanke and LUI 2015) An exchange rate
refers to the price of the country’s currency with respect to another country’s currency.
Exchange rates are mainly determined in foreign exchange market. Relative prices of products
and services are vital for determining changes in exchange rates over long periods. Purchasing
power parity (PPP) signifies that the exchange rate between currencies is equivalent to ratio of
currencies. It is determined in every nation based on their cost of living as well as inflation
rates. This economic theory however compares various nations’ currencies through basket of
product approach. Terms of trade (TOT) indicates the prices of country’s exports relative to
their import prices. Fluctuation in terms of trade leads to changes in prices of exports and
import goods. Foreign exchange market refers to the market in which the participants of the
nation have the ability to purchase, sell, speculate and exchange on the currencies (Frenkel and
Johnson 2015). The operations of foreign exchange market mainly includes- transfer of funds
between two nations, providing short term credit to importers to increase the flow of products
between countries and hedging risk of foreign exchange. The central banks of the respective
nation plays vital role in this foreign exchange market. These banks control supply of money,
inflation, and interest rates. They utilize foreign exchange reserves for stabilizing market. The
government usually intervenes in the FX market in order to influence exchange rate level and
stabilize it for improving the health of the nation.

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Discussion
There are several factors that influence foreign exchange rates. Fluctuations in relative
price level of goods and services are one of the main factors that affect the foreign exchange
rates. If the nations do not impose restrictions on trade, the exchange rate between these two
nation’s currencies is permitted to adjust accordingly. Moreover, if the transport cost of
products between the nations is nil, then exchange rate between currencies might reflect
differences in level of price in these two nations. The theory of purchasing power parity mainly
compares the relative prices of goods between the nations. Gopinath, Helpman and Rogoff
(2014) propound that fluctuations in level of product prices brings about variation in foreign
exchange rate. Similarly, fluctuations in exchange rates might result to variation in relative price
level. Hence, this theory assumes that there has been direct linkage between FX rate and
purchasing power of the nation’s currencies. In addition, amendment in international prices of
products and services creates movements in the exchange rates and vice versa. This means that
if there is decline in exchange rate, the relative price level of foreign products and services
increases. On the other hand, if there is an increase in exchange rate, then relative prices of
foreign products will increase.
The foreign exchange rate apt to rest at that point that signifies equality between
purchasing powers of two currencies. This particular point is referred to as the PPP. Under
autonomous paper standards system, the currency’s external value mainly depends on the
purchasing power of this specific currency with respect to another currency (Mankiw 2014).
However, under such system, exchange rate is mainly determined by PPP of various currencies
in different nations. The actual exchange rate between the nations seldom reflects two
currencies purchasing power. The reason behind this is that the government of respective
nations has either control exchange rates or prices or inflicts restriction on both export as well
as import of products. Thus, changes in FX rates tend to impact on the PPP.
The terms of trade usually measures the exchange rate of one commodity for another when
trade occurs between two nations. The Foreign exchange rate has huge influence on terms of
trade. In general, weaker currency enhances exports and makes imports highly expensive.

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Volatility in rate of exchange is mainly caused by variation in terms of trade as increase in value
of the currency of the nation reduces domestic import prices but might not directly impact on
the export product prices. Reduction in exchange rate decreases terms of trade while
appreciation in exchange rate increases terms of trade. Melvin and Norrbin (2017) states that,
direct as well as indirect impact of change in exchange rate leads to change in trade surplus or
trade deficit. It has been stated Reisman (2013) that, depreciation in exchange rate should be
sufficiently huge to cause impact on the balance of trade. In the short run, the balance in trade
will deteriorate the import value in foreign currency that is multiplied by magnitude of rise in
foreign currency price. According to standard theory of trade, the balance of trade is predicted
to be directly influenced by depreciation. This theory also defines that the balance in trade in
the nation is supposed to rise after depreciation in real exchange rate. Menkhoff (2013) found
out that depreciation in foreign exchange rate influences terms of trade.
The terms of trade is mainly determined by each nation’s reciprocal demand for the
commodity of other nations. Moreover, reciprocal demand is governed by demand as well as
supply conditions. Therefore, the demand intensity by other nations for a particular nation’s
exports and the demand intensity for imports from other nations are the vital factors, which
determine terms of trade. Apart from this, cost conditions of the exported commodities and
that imported have also vital role in terms of trade determination.
Intervention in the foreign exchange market refers to the monetary policy tool at which the
central bank takes participatory role for impacting transfer rate of monetary fund of the
country’s currency (Noussair, Plott and Riezman 2013). Intervention in FX market usually comes
in two sections, which includes-
 Firstly, the nations that are highly dependent on exports and deals with appreciating
currency, the government might try to intervene. Therefore, by weakening their
currency, they are making export products highly competitive in global market.
 Secondly, there are times when intervention might be short time reactionary for
particular event. However, these events might cause the nation’s currency move in
particular direction in less time space.

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There are certain circumstances at which the government of the respective nations
intervenes in the FX market in order to influence exchange rate level. The government adopts
certain methods for influencing exchange rate, which includes-
 Reserves as well as borrowing- If the government wants in maintaining original value
and exchange rate value decreases, then it might use foreign exchange reserves.
 Varying interest rates- Rise in interest rates causes flow of money as well as increase
sterling demand (Melvin and Norrbin 2017). Moreover, it does not have impact on
depressing demand in the nation. In this case, the government might be reluctant to
reduce demand for increasing the currency value.
 Borrowing- At times, the government might borrow foreign currencies from the foreign
countries.
 Reducing inflation rate- The government might decrease aggregate demand through
tighter fiscal or monetary policy.
Therefore, the main reasons for which government of respective countries intervenes in the
foreign exchange market are given below:
 In order to correct for failures in the market
 In order to reverse growth in respective nation’s deficit in trade
 In order to enhance the performance of the nation.
The government of the respective countries achieves following objectives by intervening in
the FX market-
 Exchange rate stability
 Prevention of undervaluation or overvaluation of nation’s currencies
 Reserving exchange for vital imports
 Encouraging as well as protecting domestic industries
 For improving balance of payments
 For curbing conspicuous consumption
 For regulating export and securities transfer

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 For repaying their foreign loans
Conclusion
From the above study, it can be concluded that there are several reasons for
fluctuations of prices between the nations such as exchange rate, terms of trade etc. Relative
prices fluctuation is one of the factors that affect foreign exchange rate. The factors that affects
changes in FX rates includes- supply as well as demand of commodities, inflation rate, political
and economic stability and government debt. Moreover, the government also intervenes in the
market for improving the economic health of the nation by stabilizing exchange rate, repaying
foreign loans, improving balance of payments etc.

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References
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