IntroductionOver the time of centuries there were various forms of currencies .Initially there was barter system
and later came silver and finally gold coins.. A majority of nations throughout the globe own their
own currencies. For instance, the United States employs the dollar as its official currency, the
European Monetary Union uses the euro, Brazil uses the real, and China uses the yuan .International
trade encompasses the reciprocal interchange of diverse currencies (or, more often, bank deposits
denominated in various currencies). When an American corporation engages in the acquisition of
foreign products, services, or financial assets, it necessitates the conversion of U.S. dollars, often in
the form of bank deposits denominated in U.S. dollars, into foreign currency, specifically bank
deposits denominated in the respective foreign currency. The foreign exchange market facilitates the
exchange of currencies and bank deposits that are denominated in certain currencies. The rates at
which currencies are exchanged, so influencing the cost of acquiring foreign commodities and
financial assets, are determined by transactions carried out in the foreign exchange market. The
global exchange rate regime has undergone substantial changes since the termination of the Bretton
Woods era. Consequently, the transition from a gold-backed fixed exchange rate system to a flexible
exchange rate regime has been completed. Moreover, the adoption of a floating exchange rate
system has facilitated the free flow of financial capital .Countries characterised by unstable economic
systems often experience significant changes in exchange rates, marked by pronounced periods of
both appreciation and depreciation, particularly under a floating exchange rate regime. The role of
excessive financialization and the exchange rate regime in exchange rate, banking, and financial
crises has become more significant, particularly during the 1990s.(Çeli ̇k. (2022). Dynamics of
Exchange Rate Fluctuations in Turkey: Evidence from Symmetric and Asymmetric Causality Analysis.
Ekonomika - Vilniaus Universitetas, 101(1), 125–141. https://doi.org/10.15388/Ekon.2022.101.1.7)
Literature -- An inadequately managed exchange rate has the potential to have detrimental effects
on economic development.
A comprehensive comprehension of the exchange rate and the many variables influencing its
fluctuations has significant importance, since both domestic and international transactions are
subject to the impact of the exchange rate. The exchange rate plays a fundamental role in connecting
the local and global markets for a wide range of products, services, and financial assets. The use of
exchange rates enables us to make comparisons between the pricing of commodities, services, and
assets that are denominated in various currencies. This is to examine the determinants that
significantly impact fluctuations in the exchange rate.The research used the Real Interest Rate (RID)
model, which is one of many models utilised to analyse the variables that influence fluctuations in
exchange rates. The investigation of the underlying mechanisms driving fluctuations in exchange
rates has consistently captivated economists worldwide. Consequently, research was conducted on
the exchange rate in many Asian countries. This study used the Real Interest Rate (RID) model to
ascertain the macroeconomic factors that influence fluctuations in the exchange rate within the
chosen Asian nations.( Patosa, J.B. and Cruz, A.T., 2013. Factors affecting exchange rate movements
in selected Asian countries. Philippine Agricultural Economics and Development Association
(PAEDA), pp.1-17.) as mentioned in the discussion a poorly managed exchange rate has deadly
effects on the economy and can give rise to black market exchange .. Which is most common in war
torn countries or countries which are under sanctions for example Lebanon , north korea, iran etc
((Bahmani-Oskooee and Tanku))
Factors effecting floating exchange rate – There are numerous factors which effect the exchange rate
of a countries currency out them we have picked 5 key elements which are considered to be most
crucial factors ..
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Inflation rate
Economic stability
Central bank policies
Foreign investment
Market liquidity
Other factors include government stability , trade balances etc ..
Inflation rates- The impact of inflation rates on currency rates is of utmost importance within a floating
exchange rate system. The correlation between inflation and exchange rates is determined by the
theory of purchasing power parity (PPP). According to this theory, assuming no transaction costs or
trade barriers, exchange rates should adapt in order to equalise the prices of comparable baskets of
products across various nations. In the context of international trade, it can be seen that when a
country encounters a comparatively lower level of inflation in relation to its trading partners, the
natural consequence is an appreciation of its currency. This appreciation is necessary in order to
uphold the country's buying power. Conversely, if a country experiences more inflation compared to
its trading partners, its currency is expected to depreciate, therefore mitigating the potential erosion
of its purchasing power.In practical applications, there are several reasons that might contribute to
departures from the purchasing power parity (PPP) relationship. Transaction costs, transportation
expenses, and the presence of non-traded products are among the tangible obstacles that hinder the
realisation of instant arbitrage possibilities. Furthermore, variances in inflation and exchange rates may
be attributed to other factors such as expectations, market flaws, and structural differences that exist
across nations. Notwithstanding these anomalies, inflation continues to be a significant determinant
of currency rates. When a nation sustains a lower level of inflation in comparison to its trading
counterparts, its currency is seen as being more stable and appealing to investors. As a result, there
has been a surge in the demand for the currency, leading to its appreciation. On the other hand,
increased inflation has the potential to diminish the worth of a currency, leading to a decline in its
value.While acknowledging the Purchasing Power Parity (PPP) conundrum, it emphasises the
significance of comprehending the connection between disparities in inflation and fluctuations in
exchange rates. This comprehension is crucial for investors, governments, and enterprises engaged in
the global marketplace, as it offers valuable insights into the determinants influencing currency
fluctuations and their consequences for international commerce and investment.( Rogoff, K., 1996.
The purchasing power parity puzzle. Journal of Economic literature, 34(2), pp.647-668.)
Economic stability -The effect of economic performance on exchange rates under a floating exchange
rate system is substantial. The value of a nation's currency is significantly influenced by its economic
health, which includes the development of its Gross Domestic Product (GDP), the status of
employment, and the political stability of its government. The appreciation of a currency is
commonly viewed as a consequence of robust economic performance because it serves to attract
foreign investment.A nation experiencing substantial economic expansion is viewed as an attractive
location for foreign investors. A robust expansion of the Gross Domestic Product (GDP) indicates
increased economic activity and the potential for profitable investment opportunities. Consequently,
this increases demand for the nation's currency in question. The increased demand may result in a
currency appreciation.Low unemployment rates are indicative of a healthy labour market and a
stable economic climate. A nation with low unemployment rates is more likely to attract
international capital and investment. The resulting increase in demand for a specific currency could
lead to its appreciation.When evaluating the economic prognosis of a country, political stability is a
significant factor that investors consider. The presence of a stable political climate mitigates
investment risks and increases a country's appeal to foreign investors. The consequent fortification of
the nation's currency results from the influx of foreign wealth.These dynamics demonstrate the
complex relationship between economic success and exchange rates. When a nation's economy
demonstrates robust performance and stability, it creates a favourable environment for foreign
investment, resulting in an increase in demand for its currency and a corresponding appreciation of
its value.By emphasising the significance of economic fundamentals, Froot and Rogoff's study
contributes significantly to our knowledge of long-term exchange rate fluctuations. This statement
emphasises the significance of several variables, such as GDP growth, unemployment rates, and
political stability, in influencing currency values and determining international trade and investment
decisions.( Froot, K.A. and Rogoff, K., 1995. Perspectives on PPP and long-run real exchange
rates. Handbook of international economics, 3, pp.1647-1688.)
Central bank policies - Exchange rates under a floating exchange rate system depend on central bank
policy, particularly interest rate movements. Increased or decreased interest rates may affect a
country's currency's investor appeal, which affects exchange rates.
An in-depth discussion of how central bank policies affect currency rates:
Central banks use interest rates for monetary policy. Raising interest rates by a central bank is often
seen as tightening monetary policy. Higher interest rates might boost earnings on currency
investments. This may attract foreign money seeking better rates, increasing domestic currency
demand and local currency appreciation. Central banks often advise on monetary policy. Investors
may adjust their tactics if they think a central bank will hike rates soon. The prospect of increased
interest rates might boost currency demand and value.Some central banks deliberately manipulate
their currency's value on the foreign exchange market. They may buy or sell currency to stabilise its
exchange rate. These initiatives may immediately affect currency values.
Gagnon and Ihrig study exchange rate pass-through, which is how central bank interest rates affect
exchange rates and inflation. Their study illuminates how monetary policy affects the foreign currency
market.
Investors, foreign traders, and policymakers must understand how central bank policies affect
currency rates. It shows the relationship between monetary policy and exchange rates and their
potential effects on a nation's economy and competitiveness.( Gagnon, J.E. and Ihrig, J., 2004.
Monetary policy and exchange rate pass‐through. International Journal of Finance & Economics, 9(4),
pp.315-338.)
Foreign investmnets -In a floating exchange rate regime, FDI and portfolio investment may affect
currency rates. Hutchison and Noy's article "How Bad Are Twins?" In 2005, the Journal of Money,
Credit, and Banking published "Output Costs of Currency and Banking Crises" on how foreign
investment affects exchange rates.
A more extensive description of how foreign investment impacts currency rates:
FDI: Foreign companies invest long-term in a nation, such as starting or buying enterprises. Large
FDI frequently signifies a good investment environment, economic stability, and growth possibilities.
Foreign investors require the indigenous currency to invest, which boosts demand and appreciation.
Portfolio Investment: Portfolio investments include stocks, bonds, and other securities. Some
investments are more liquid and short-term than FDI. A nation with a good investment climate may
attract more portfolio investment, which may boost currency demand and appreciation.
Investor Confidence Foreign investment indicates economic optimism. Good economic and political
news may attract international investors, raising the home currency's value.
Currency Pegging: Certain nations peg their currencies to others. This exchange rate stability
strategy attracts foreign investment. The country's central bank must actively regulate the currency
rate to preserve the peg.Understanding how foreign investment affects currency rates is crucial for
investors, firms, and governments to foster foreign capital inflows. Foreign investment boosts
currency appreciation, economic development, and international commerce and investment.(
Hutchison, M.M. and Noy, I., 2005. How bad are twins? Output costs of currency and banking
crises. Journal of Money, credit and Banking, pp.725-752.)
Government intervention -In a floating exchange rate regime, government and central bank market
actions affect exchange rates. Edison and Pauls' 1993 Journal of Monetary Economics work, "A Reassessment of the Relationship Between Real Exchange Rates and Real Interest Rates: 1974–1990,"
illuminates how such interventions affect currency rates.
More on how market actions effect currency rates:
Foreign Exchange Market Interventions: Foreign exchange market interventions include governments
and central banks purchasing or selling their currency. These operations impact the exchange rate
and stabilise currencies. A central bank may act to slow currency depreciation that may hurt the
economy.
2. Stabilisation and Speculation: Market interventions reduce exchange rate volatility to stabilise a
country's currency. They may worry about currency volatility affecting commerce, inflation, or the
economy. Intervention affects trading methods, thus speculators and traders watch for it.
3. Exchange Rate Impact: Market actions may cause short-term exchange rate fluctuations. Central
banks purchase their own currency to boost demand and appreciation. Its currency may depreciate if
sold.
4. Market Expectations: Intervention efficacy frequently relies on market expectations. Traders and
investors see a central bank's operations as transitory or permanent. Market sentiment and currency
movements are affected by central bank exchange rate commitment expectations.
5. Conflict and Debate: Currency interventions' efficacy and ethics are debated by economists and
policymakers. Some think interventions stabilise markets and prevent currency crises, while others
say they distort markets and create moral hazard.
Edison and Pauls' study helps us comprehend actual exchange rates and real interest rates, which is
crucial for assessing currency interventions. Market interventions are used by nations to affect
currency prices, although their efficacy relies on market mood and the conditions.( Edison, H.J. and
Pauls, B.D., 1993. A re-assessment of the relationship between real exchange rates and real interest
rates: 1974–1990. Journal of Monetary Economics, 31(2), pp.165-187.)
The establishment of limitations on foreign individuals or entities acquiring local enterprises and
properties has the potential to have an impact on the exchange rate of the domestic currency. When
the implementation of such limitations occurs, they are often seen as protective measures with the
intention of preserving domestic assets. This view has the potential to discourage foreign investors
and diminish the demand for the native currency, resulting in currency appreciation. A stronger
currency might potentially provide several impacts.The Impact on Trade: The appreciation of a
nation's currency may lead to an increase in the price of its exports for international purchasers,
hence possibly diminishing the demand for exports and exerting adverse effects on trade balances.
The appreciation of a nation's currency may diminish the competitive advantage of its products and
services in the global marketplace, hence possibly affecting businesses that heavily rely on
exporting.According to Eichengreen (1999), the implementation of restrictive measures has the
potential to impact the general attitude of investors and their confidence in the economic landscape of
the nation.( Eichengreen, B.J., 1999. Toward a new international financial architecture: a practical
post-Asia agenda. Peterson Institute Press: All Books.)Nevertheless, the magnitude of these
consequences is contingent upon the particular circumstances, the worldwide economic climate, and
the anticipated enduring implications of the limitations. The actual result is heavily influenced by policy
actions and market factors.