Determinant Of Exchange RateDeterminant Of Exchange Rate

The exchange rate of any currency can be determined by many factors such as economic factors, political conditions and market psychology. Models and theories has been developed to explain currency fluctuations in a floating exchange regime, but in a fixed exchange rate regime, rates are decided by it's government. However, none of these models succeeded in explaining exchange rate and volatility in longer time frames.
          Economic factors like economic policy by government agencies, central banks and economic conditions such as economic report and economic indicators play a major role in determining the exchange rate of a currency.
Economic policy like government fiscal policy, monetary policy and government deficit and surpluses make the market to narrow or widen due to positive or negative budget deficit and has a reflection on the forex value of a currency. Economic conditions include balance of trade levels and trends, this is the trade flow between countries and shows the demand of goods and services, which implies demand for that country's currency to make trade. Surpluses and deficit in goods and services shows competence of that nation's economy. Example trade deficit may have a negative impact on a country's currency.
Inflation level and trends, if there is a high inflation the currency value will drop, because inflation reduces the the purchasing power and demand for that particular currency or forex. Hence, a currency may strengthen if inflation is raising because of the expectation that the central bank will raise short-term interest rate to curb inflation. Economic growth and health implies that the more healthy and robust a country is the better the forex rates and performance and more demand for that country's currency or forex, these type of growth and health may be GDP, employment rate, retail sales, capacity etc. Productivity of the economy, increased productivity should positively influence the currency value. It's effect is more prominent if the increase is in the traded sector.
        Political conditions like internal, regional, international political conditions and events can have a deep effect on the currency markets. All exchange rate are easily influenced by political instability and anticipation by the new ruling party. Political unrest and instability can have a negative impact on a nation's economy or exchange rate. In a country experiencing financial problems, the raise of  a political faction that is perceived to be fiscally responsible can have a the opposite effect. Also, events in one country may spur positive or negative interest in a neighboring country and in the process, effect it's country.
        Market psychology and forex traders views influence the forex market in various ways, like Flight to quality, this is a situation whereby investors move their assets to safe haven, otherwise known as capital flight, this result in demand for stronger currencies at higher prices to weaker ones eg US dollar, Swiss Franc and gold are refered to as safe haven during political or economic unrest. Long term trends, in this case, currency move in visible long term trends, although currency do not have an annual growing season like physical commodities, business cycles do make them self  felt. Cycle analysis looks at long-term price trends that may raise from economic to political trends. "Buy the rumor, sell the fact" this can be applied in many forex situation, this is the tendency for the price of a currency to reflect the impact of a particular action before it occurs, and when the anticipated event come to pass, react in the opposite direction and can also be refered to as "Oversold" or"Overbought". Economic numbers reflect economic policy, some reports and numbers take a talisman effect: the number itself becomes important to forex market psychology and may have an immediate effect on short-term forex market moves. What to watch can change overtime. Example in recent years money supply, employment rate, trade balance figures and inflation numbers have all taken turn in spotlight. Technical trading, in other markets, history price movements in a currency pair such as EUR/USD can form patterns that forex traders may attempt to use. Many forex traders study price charts in other to identify such patterns.
           Theories and models such as international parity conditions that deal with relative purchasing power parity, interest rate parity, domestic fisher effect, international fishers effect, balance of payment model that focuses on tradable goods and services, ignoring the increase role of capital flows and asset market model that views currency as an important asset for constructing investment portfolios. But none of these models succeeded in explaining exchange rate and volatility in longer time frames but can be used on short time frames.

  Finally, the forex or exchange rate of any country's currency can be determined by a combination of factors that can be political condition, economic factors and market psychology, theories and models can also be used in short time frame.

by Thompson Chukwuemeka
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