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What factors determine and intervene in foreign exchange rates? Explain your arguments

by providing relevant theoretical/ empirical literature and using relevant data.

Name

Course

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Contents

Abstract............................................................................................................................................3

Introduction......................................................................................................................................3

Literature Review............................................................................................................................4

Analysis and recommendations.......................................................................................................6

Conclusion.......................................................................................................................................7

References........................................................................................................................................8
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Abstract

Multiple factors affect the value of one currency relative to another, and each can have both good

and negative effects, depending on the specifics. They will also affect the global community.

Central banks may also try to influence the outcomes of foreign markets for economic benefit.

Despite the promising nature of the interventions, they must be carried out without hiccups to

preserve the efficacy of the laws that have already been approved. For the sake of stability in the

foreign exchange markets, perhaps it would be best if the central bank were entirely independent

of and apart from the government. Government elites may make bad economic decisions, but

central banks may cushion the blow. Various factors like interest rates, inflation rates,

government laws, relative income, and speculations are considered. Despite certain similarities,

each component is treated separately from the others since it has its specific effects. When the

central bank steps in to stabilise the currency market, the economy becomes more robust, growth

accelerates, and inflation is kept under control.

Introduction

Changes in the value of a country's currency could prompt the government of that country to

adjust its foreign policy. When the value of a country's currency increases, the cost of imported

items goes down, while the opposite is true for the cost of goods that are exported from that

country. When a country's currency loses value, the cost of commodities bought from other

countries as well as goods exported to other countries becomes more expensive. When the

exchange rate of a country goes up, it can be detrimental to that nation's trade balance; when it

goes down, however, it can be beneficial to that balance.

The intervention of central banks in foreign markets has developed into a mature practice over

time. Even though intervention has become less common in many countries, others, such as

Japan, continue to engage in the practice. A variety of different circumstances call for action to

be taken by the central bank. The accomplishment of macroeconomic goals, such as price

stability, economic development, and job creation, is the major emphasis of this organisation

(Ilzetzki and Rogoff, 2019). The aims of intervention methods are informed by several variables,

including a nation's level of integration and the development of its financial market, the stage of

development the country is now in, and its general shock vulnerability. The effectiveness of the

market reserves, the degree to which they can influence the exchange rate, and the extent to

which they may be able to reduce swings in the exchange rate have been the three most

important and urgent steps to take (Ilzetzki and Rogoff, 2019).

Literature Review

Numerous scholars have examined the myriad factors, such as government intervention,

inflation, interest rate differentials, income disparities, and alterations in expectations, that

influence currency exchange rates.

Because of how this affects the demand and supply of currencies, currency exchange rates are

influenced. When inflation falls, the value of a country's currency tends to rise. The lower

inflation rate in postwar Europe contributed to, for example, a long-term appreciation between

Germany and Denmark. Inflation rates were lowest in Switzerland, Germany, and Japan around

the end of the twentieth century. It took some time, but the two largest countries in North

America have finally accomplished this (Beckmann et al, 2020). If we look at the markets in the
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United States and Japan, we may find two corporations selling essentially the same goods to one

another.

The interest rates that are being used or that have been used in a certain nation at a given point in

time (Alagidede and Ibrahim, 2017). If inflation in the United States grows but it does not rise in

Japan, then more people in the United States will be interested in purchasing Japanese goods,

which will drive up demand in Japan and drive up demand for yen in the United States. The

availability of dollars will decline in tandem with the falling demand for American goods in

Japan. Even if there is an increase in inflation in Japan but not in the United States, the opposite

will still happen (Sternberg et al 2021).

Investing in foreign assets can be impacted by shifts in the demand for and supply of a particular

currency, both of which, as noted by Engel, are impacted by interest rate swings. If interest rates

in the United Kingdom were to follow the example set by those in the United States, the return

on savings would be much improved (Neves et al, 2020). Because of the increased returns that

investors in the United Kingdom may expect from their savings accounts, investors in the United

Kingdom and elsewhere will be motivated to save more money and put more of their money to

work in the country (Helísek, 2019). The United States dollar, which is the currency used by the

United States, has seen an increase in demand as a result of increasing deposits, both in the UK

market and outside of it. The value of the dollar is going to go up as a direct result of the

increasing demand. As a consequence of this, one of the most important aspects that play a role

in determining the value of a certain currency is the interest rate environment that exists or

predominates in a particular nation at any given time (Feng et al, 2021).

Since the number of imports that consumers seek is a good indication of the exchange rate, Kim

and Sheen investigated whether or not relative income plays a role in the foreign currency

market as well (Kim and Sheen, 2018). Take for example country A, the United Kingdom, and

country B, the United States, where country A experiences an increase in their level of life while

country B does not. The demand curve is going to go upward as a result of both the increase in

income in Area A and the increase in demand for items in Area B. The increase in the

equilibrium exchange rate can be attributed to the absence of scheduled modifications to the

supply schedule (Feng et al, 2021). The cost of one currency expressed in another currency will

go up if the collection schedule is not altered. If the average income in nation A falls but the

average income in country B remains the same, then country A will buy fewer items from

country B. It is also true that as revenue in nation B decreases, country A will buy fewer items

from country A. This relationship holds in reverse as well. As a direct consequence of this, the

demand curve will go downward (Feng et al, 2021).

To influence market exchange rates, the government might use several tools. The role of the

government in influencing currency rates is reflected in several of the aforementioned factors. If

a foreign government implements them, they are binding on all businesses, both home and

foreign (Poyser, 2019). Currency exchange rates, income levels, and trade barriers between

countries are just a few of the many factors that impact global trade. For instance, if the number

of dollars was to increase but the exchange rate between the UK and the US stayed the same, this

would be an appropriate scenario (Poyser, 2019). An excessive tax on interest-rate income from

overseas assets will discourage investors from trading dollars for pounds. Since this will either

increase demand or have no impact on the market, there will be a countervailing effect. To make

Chinese exports more competitive, the Chinese government has chosen to keep the value of the
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yuan at artificially low levels. To do so would need to purchase US dollar-based assets, which

would increase the value of the USD vs the CNY (Poyser, 2019).

Cavallino argues that due to inherent developments in their respective fields, most global

organisations and industries are equipped to respond to news and other information disseminated

by media sources (Cavallino, 2019). No matter how the institutions react, it will affect the

financial and currency exchange markets. Either a decrease or an increase in exchange rates may

result from the results. The currency of a nation whose inflation rates have been in the news may

be sold by traders, raising supply but not altering demand (Caspi et al, 2022). Supply will

decrease and the price will rise as a result. When demand rises, investors tend to buy currency in

large quantities, restoring a sense of stability. Changes in exchange rates are mostly driven by

sentiment in the financial markets, which is reflected in underlying economic conditions. One

such example is the depreciation of the British pound after the country voted to withdraw from

the European Union. It was widely expected by the financial community that the UK's attempts

to entice investors with the euro would fail (Rolfe et al, 2020)

Natural disasters on a national scale, such as cyclones, tornadoes, and floods, can occur with

little to no advance notice. The COVID-19 pandemic has already claimed the lives of thousands

of individuals throughout the world. The economic and social costs of pandemics and natural

disasters include lost productivity and lives (Rolfe et al, 2020). There is a higher demand for

foreign currency during times of crisis since the local currency is worth less. Consequently, this

may cause unwanted alterations in currency exchange rates. Because of Covid-19, foreign

exchange markets suffered losses (Burger et al, 2020). Global economic growth has slowed

significantly as a result of several countries imposing trade and travel restrictions, or lockdowns.

Currency value was reduced as a result of higher import prices for food and other requirements
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caused by the Rohingya crisis. As a result, the global supply chain is experiencing considerable

challenges as the domestic and global trade markets decline. Therefore, the freeing exchange

market becomes more volatile, adding to the economic stress on the country (Liu & Lee, 2022).

Starting in the early 1990s, the exchange rate has been subject to intervention from several

different regimes, with the growing market economies maintaining authority over the monetary

instrument. The authors Moagăr et al state that this move was made to keep prices from

fluctuating too much from country to country (Moagăr et al, 2019). Foreign exchange operations

are essential to the stability of currencies managed by boards like Hong Kong and Bulgaria, for

example. Several countries in East Asia kept using basket pegs long after they had become

obsolete. One of the primary reasons governments intervene in the market to influence exchange

rates is to control inflation and maintain economic stability. The exchange rate has served as a

nominal anchor for monetary policies, allowing for efficient control of inflation. Both Brazil and

Argentina instituted quasi-fixed exchange systems and currency boards to do away with high

inflation regimes (Feng et al, 2021). China still plans to liberalise its currency market,

notwithstanding the declining impact of nominal anchors on exchange rates. Inflation has also

been controlled and monetary policy supported through exchange rate methods in Israel and

Singapore (Liu & Lee, 2022). The second is that we must strike a balance with the outside world

while simultaneously encouraging growth and boosting competitiveness. To avoid a situation

where the actual exchange rate does not reflect the achievement of external equilibrium,

exchange rate targets have been implemented (Yakub et al, 2019). A rapid turnaround of the

seemingly unsustainable account deficits is possible, and this has been the goal all along.

Thirdly, depreciation of the coin would harm the financial position of enterprises that borrow

money in foreign currencies in the event of currency mismatches in a given country such that
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foreign obligations are not supported in full by the assets of the foreign currency, thereby

preventing a crisis (Yakub et al, 2019). A substantial devaluation might put the financial system

at risk in the current environment.

Determination of exchange rates

Since demand for British currency has increased, the exchange rate between the British pound

and the United States dollar has strengthened, increasing the worth of one pound from $1.50 to

$1.70.

Exchange Rate Determinants

Exchange rates are affected by a wide variety of factors, including interest rates, investor

sentiment, the current account of the balance of payments, GDP growth, and inflation in other

currencies.

For example:
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 If U.S. firms become relatively more competitive, resulting in increased demand for

American goods, the dollar would appreciate (increase in value).

 If global markets were to become gloomy about the future of the US economy, the dollar

would fall in value.

Examples

Inflation: British exports will become more competitive as a result of lower inflation in the

UK compared to other countries, increasing demand for the pound. British consumers will be

less interested in purchasing imported items as a result of their decreased competitiveness.

Therefore, countries with lower inflation rates typically have more stable currencies.

Inflation was significantly lower in postwar Germany, which helped the D-long-term Mark

rise in value.

Interest rates: If interest rates in the UK were greater, more people would be willing to

deposit their money there. The interest rate on savings accounts at UK banks is greater than

the average. That means there will be more demand for Sterling. This is a crucial factor in the

short-term valuation of a currency, and it is sometimes referred to as "hot money flows."

Modest rate hike in the United Kingdom

Higher Interest Rates on UK Savings Accounts

Since higher interest rates are attractive, "hot money" comes into the market.
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Demand for the British pound has risen.

Gains in purchasing power of pound sterling

Speculation: If speculators anticipate a future rise in the value of the pound, they will want

to pay a higher price for sterling right now. More people wanting to buy means higher prices.

This means that the financial markets sentiments, rather than underlying economic

fundamentals, typically dictate variations in the exchange rate. For instance, if the markets

see recent data as increasing the chance of an increase in interest rates, the value of the pound

is likely to rise.

Change in competitiveness: There would be an increase in the value of the pound if British

exports were more successful. For instance, the value of the pound may rise if long-term

trends in the UK labour market and productivity increase, making British exports more

competitive on the worldwide market. I suppose it's like having low inflation.

Analysis

Numerous factors contribute to the efficient operation of the foreign exchange market. To

succeed and speed up the economy's growth, one must work hard to overcome the obstacles set

in place by other people (Madanaguli et al, 2022). Every entrepreneur with global expansion

aspirations must think about foreign inflation rates. If a country wants to keep its currency
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strong, it must keep inflation low. For economic progress to continue, stable exchange rates are

required to prevent a surge in the supply of currency that would make it unattractive to foreign

investors (Madanaguli et al, 2022).

When it comes to keeping inflation low and the money supply under control, central banks play a

pivotal role. Central bank intervention helps prevent a monetary policy crisis caused by an

extreme inflation situation (Krause, 2019). For this reason, a stable monetary authority is crucial

to sound economic policy. A separate location for the central bank's operations would help shield

it from interference from short-term economic or political forces. The strength of a country's

currency in international trade is a key indicator of economic health (Krause, 2019).

Domestic markets are frequently less regulated by the government, which is why many investors

choose them. They promise a fast-rising GDP and a wide variety of investment opportunities,

which draws more money and ultimately results in higher currency values. There are several

tools available to governments to maintain favourable exchange rates for their currency (Kar,

2021). They are crucial to the growth of regional economies because, via sound monetary policy,

they protect markets from the destabilising effects of inflation(Kar, 2021).

Intervention effective

The research on the topic is divided, and there is much debate on the efficacy of foreign currency

intervention. Central bank policymakers' perspectives appear to differ from the empirical data

given in academic studies. Surveys undertaken by central banks have shown results that are

generally in line with the success of interventions.

Researchers outside of the central banking sector have found different outcomes in empirical

studies on the effectiveness of foreign exchange intervention. Positively, Menkhoff's (2010)

empirical study demonstrates that the level of the exchange rate can be significantly affected in

the desired direction by foreign currency intervention. While he did find that intervention

reduced volatility over the long term, he also discovered that it increased volatility in the short

term. Adler and Tovar (2011) argue that intervention is effective in lowering the rate of exchange

rate appreciation when capital account openness is low.

Recommendations

The following are some suggestions for influencing the foreign currency market:

1. For Central banks' intervention programmes to be successful, it is necessary to precisely

specify both the exchange rate to be used and the target exchange rate. The value of

buying or selling a currency may be measured in several different ways, some of which

include the nominal effective exchange rate, the real bilateral exchange rate, the nominal

bilateral exchange rate, and the effective exchange rate.

2. A quick increase in the rate of change in exchange rates, an increase in the rate of

unjustifiable volatility, and a sudden shift in the market's composition or turnover rate are

three significant signals that may be utilised to detect market illiquidity. These three

components are crucial to the effectiveness of the intervention as a whole.

3. The best way to interfere with the levels of exchange rates is to frequently assess the

macroeconomic policy mix, the nature of economic shocks, the extent to which the

economy is dollarized, and the degree to which capital is mobile.

4. The ability to interfere, and by how much, should, however, be left to central banks.

Because of the control, central banks would be able to adapt the policy to fluctuating

market conditions.
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5. The government should move quickly to stabilise foreign currency markets and restore

economic growth in the wake of disastrous occurrences like the Covid-19 pandemic.

Conclusion

The demand for, and hence the value of, a currency is affected by a variety of factors, including

the interest rates that have been set or that are prevailing in a country at any given time. Import

demand and, by extension, the currency exchange rate, are affected by the income gap between

the two countries. The value of the currency will increase if the supply plan is not changed. If the

government levies a high tax on interest earned on investments stored overseas, investors would

be discouraged from engaging in currency exchanges. Changes in exchange rates are mostly

driven by sentiment in the financial markets, which is reflected in underlying economic

conditions. The exchange rate, as the nominal anchor for monetary actions, has been utilised to

manage inflation.
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