Wednesday 7 December 2022
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EconomyHow currency exchange rates are determined

How currency exchange rates are determined

Amid constant news of the Indian falling and sometimes rising again vis-à-vis the US dollar, the lay want to know how these rates are determined and who decides the values. The rate of the currency of a country with respect to that of another drives international trade and commerce. When a country’s currency rate rises in the forex market, its imports tend to get cheaper.

Conversely, when the exchange rate of its national currency falls, the imports get pricier. Therefore, there is a constant tussle between importers and exporters of every country, with the former wanting its currency to be dearer so that it can buy things from abroad at a cheaper rate while the latter pushes for a cheaper currency so that buyers find the country's goods more affordable or competitively priced.

It's important to have a strong and stable currency to make the most of the goods sold by a country in international trade. The currency exchange rates are set in two different ways: fixed rate and floating exchange rate.

When the exchange rate is fixed, it is set in relation to another currency by the nation’s government through its central bank (the RBI in the case of India, Bank of England in the case of England, the US Federal Bank in the case of the US, etc). The countries that determine their own currencies against the US dollar include Saudi Arabia and China. 

Macro factors, the demand and supply of the currency, on the other hand, determine a floating exchange rate. 

In tandem with the traditional economic fundamentals, the exchange rate rises with demand, and declines with it. For instance, when there is an increased demand of the British pound-sterling (GBP) among American traders and merchants, the price of pounds in relation to US dollars (USD) is likely to increase, but again, it is subject to a range of other geopolitical factors as well.

Intervention to correct market 'excesses'

However, even in floating rate, the countries often intervene to influence their currency to make it suit to their advantage. There are scores of other factors in international trade, currency markets and the overall global that influence the currency exchange rates.

There are several factors that together influence the exchange rate of a given currency with respect to another. They are inflation, GDP data, changes in interest rate and unemployment. There are a range of short-term factors that influence the exchange rate — such as every-day demand and supply, natural or economic disasters and, at times, speculations. For instance, when the supply races past the currency’s demand, the exchange rate will fall and when the demand exceeds its supply, the exchange rate will rise.

When there is a substantial fall or rise in the value of a currency in relation to another, the central bank tends to intervene and either buys or sells the currency to reduce the volatility.

Other reasons that influence the currency’s exchange rate are the stability of government and geopolitical risks, which speak of the consistency of stable governance in the country and the world around it, impacting international trade and also the currencies that drive it.

Overall, a number of factors that include demand and supply, macroeconomic factors, geo-political stability, interest rates, GDP data, among other reasons, determine the exchange rate between two given currencies.

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