Exchange rates are the price of a country’s currency in terms of another country’s currency. For example, the Japanese yen is pegged to the United States dollar which is known as the USD/JPY exchange rate. This in turn, means that exchange rates have two components, the domestic currency and a foreign currency, which can be quoted either directly or indirectly. A direct quotation is the price of a unit of foreign currency expressed in terms of a domestic currency, whereas, an indirect quotation is the price of 1 unit of domestic currency expressed in terms of a foreign currency. An exchange rate that does not possess the domestic currency as one of the two currency components is called a cross currency/cross rate which in turn is also known as a currency quotation, the foreign exchange rate or forex rate.
In the above diagram , an increase in demand for pound from the US shifts the demand curve to the right to D2 causing the pound to appreciate and the dollar to depreciate. An increase in the supply curve to the right meaning that there is an increase in the supply of pounds to the US market will cause a new equilibrium thus lowering the exchange rate; appreciating the dollar.
There are two parts to an exchange rate being the base currency and a counter currency. A direct quotation has the foreign currency is the base and the domestic currency is the counter whereas in an indirect quotation the domestic currency is the base and the foreign currency is the counter. Most exchange rates have the base currency as the United States dollar and other currencies as the counter currency; however, there are a few exclusions to this rule, as the euro and the Commonwealth currencies, for example, like the British pound, Australian dollar and New Zealand dollar. Generally, exchange rates for most major currencies are expressed to four decimal places excepting the currency quotation involving the Japanese Yen, which is quoted to two decimal places.
Movement in the exchange rate has been said to be caused by changes in demand and supply of currencies which has been tested by (Rugman and Hodgetts, 2006) and Madura (2006). Volatility in exchange rate could be found by the help of different macroeconomic factors that affect supply and demand, thus when movement occurs in any given exchange rate, the new rate is determined at equilibrium, where supply and demand meet. Furthermore, Ray (2008) found that there is positive relationship between macroeconomic variables and the exchange rate where the relationship is positive when time factor is involved.
Aim of Study
This paper will aim to find which macroeconomic variables determine exchange rates relative to the United States dollar. The variables chosen have all been tested in previous literature against exchange rates, thus knowing that there may be some sort of link. The three currency pairs picked are the British pound, Japanese Yen and the Swiss Franc all relative to the United...