I.2.1 Factors influencing the exchange rate
There are a several factors which can influence the exchange rate of a given country such as interest rate of a country, inflation rate and money supply. In some reason non-theoretical or non-economical factors can influence the exchange rate to appreciate or depreciate against the other currencies.
1. Inflation rate
How price and inflation rate can affect the exchange rate can be explained by Purchasing Power Parity (PPP) theory. In other words, PPP theory suggests that, in a long-term domestic inflation can influence the exchange rate. For example, a country with lower inflation exhibits an increasing currency value, as its purchasing power ...view middle of the document...
5. Money Supply
Ultimately, change in exchange rate is the relationship between the national currencies of countries. Therefore, it is obvious that the relative supply of money affects exchange rate. More the amount of money circulating in the international level, value of currency will be relatively cheaper. When money supply of foreign currency is constant on foreign market, if our country’s total money supply increases, then the total ratio of the money supply changes in the market. This means that our currency is depreciated.
6. Foreign direct investment (FDI)
Due to increases in foreign direct investment, the supply of foreign currency will rise and eventually will cause the nominal appreciation of the national currency. Inflow of Foreign direct investment (FDI) is the reason of increase in production and appreciation of the national currency. However, in long-term, effective FDI leads to GDP growth and eventually demand of national currency exchange rate in the economy weakens.
7. Terms of trade