What are the Factors that Affect the Exchange Rate?

The exchange rate is subject to market forces, hence, the factors affecting the exchange rate are just factors affecting the supply and demand of a currency. There are 7 factors that affect the Exchange Rate, they are:

• Interest rate differential;

• Domestic economic growth;

• Inflation rates;

• Overseas economic growth;

• Terms of trade;

• Confidence; and

• Government budget position.

Factor #1: Interest Rate Differential

The interest rate differential is the difference between Australia's cash rate and the cash rate of other countries. The interest rate differential tends to influence volatile flows of portfolio investment. If the interest rate differential is high, then foreign investors will divert portfolio investment into Australia to gain a higher return on their investment. An increase in foreign investment is an increase in a credit transaction of the balance of payments which will increase demand and appreciation of the currency. If the interest differential is small, then portfolio investment into Australia will diminish, decreasing demand and depreciating the currency.

Factor #2: Domestic Economic Growth

The rate of domestic economic growth tends to influence the level of imports. High domestic economic growth will increase imports as businesses purchase more capital goods to produce more goods and services to meet growing demand, while households will use additional income and confidence to increase expenditure on imports such as personal travel. An increase in imports is an increase in a debit transaction which will increase the supply of a currency and depreciate the currency.

Factor #3: Inflation Rates

Inflation affects the international competitiveness of a country's goods and services. If Australia's inflation rate is higher than Australia's trading partners, then inflation will position an economy's exports as more expensive and internationally uncompetitive, causing a fall in export values. In addition, import values will increase as the price of imports are cheaper as their price rises are slower. Inflation that is greater than trading partners will decrease exports, reducing demand for a currency and increasing imports, which will increase the supply of a currency, causing a depreciation of the currency.

Factor #4: Overseas Economic Growth

Overseas economic growth tends to determine the demand for Australia's exports. High economic growth amongst our trading partners will increase export values, a credit transaction that will increase the demand for a currency, causing an appreciation of the price of a currency. The growth of countries such as China, Japan and the United States often influences world commodity prices.

Factor #5: Terms of Trade

The terms of trade determine the prices of exports relative to imports. An increase in the terms of trade from an increase in export prices relative to import prices will increase export values, as it is a credit transaction it will increase the demand for the currency and cause the currency to appreciate. If the increase in the terms of trade was caused by a fall in import prices relative to export prices, then import values will decrease. As a fall in imports is a fall in a debit transaction, this will cause supply to decrease and cause the currency to appreciate.

To put it simply:

• Increase in terms of trade = currency appreciation

• Decrease in terms of trade = currency depreciation

Factor #6: Confidence

Foreign investment is heavily determined by confidence factors. International capital flows could increase from factors such as speculation or jaw-boning by the Reserve Bank.

• Jaw-boning: Where a central bank speculates on future movements in the cash rate.

• Speculation: Investors perceived belief in the future value of a currency (positive or negative).

Factor #7: Government Budget Position

Deficit budgets are often financed by overseas borrowings, which will increase foreign investment and increasing credit transactions which will increase demand and appreciation of the currency. This is also known as net-export crowding out, to which a government budget deficit can discourage economic activity by appreciating the currency. Surplus budgets often use funds to pay down government debt and can also be invested in special funds that often invest overseas. These are recorded as an increase in Australian investment, and an increase in a debit transaction, which will increase the supply of the currency causing a depreciation.