The value of a currency against another is based on demand. Greater demand makes a currency stronger and vice versa. When there is a good inflow of dollars in India, the value of dollar will go down and value of Rupees will go up, because Rupees will be required to convert all dollars.
However, there are many determinants of the exchange rates of a particular currency against another currency. If these determinant factors are favorable to a country, there is a possibility that value of that country’s currency will rise.
Some of these determinants are:
- International Parity Conditions
- Balance of Payments
- Economic Policies of a government (Fiscal Policy, Budget, Investment policy and Foreign Trade Policies) and a country’s central Bank (Cost of money, interest rates, monetary policy)
- General macroeconomic conditions of the country
- Inflation levels and trends
- Balance of Trade
- Market Psychology & perception
- General political stability
There are two types of exchange rate regimes. One is fixed exchange rate regime where the exchange rates are decided by the government. Another is floating exchange rate regime (an example is China, but now the Chinese leaders say that it will switch to Floating Rate regime very soon). In most countries Floating Exchange Rate regime prevails. In floating exchange rate regime, the combined forces of the market and the above determinants decide the exchange rate.
The International parity conditions also include interest rate parity, Domestic fisher effect and international fisher effect.
The balance of trade affects the rates indicating a demand for a currency. Trade surplus may have a positive impact and trade deficit may have a negative impact on country’s currency. Inflation weakens the domestic currency. (However, in certain situations the inflation may lead to strengthening of the currency in anticipation of moves of central bank to hike the interest rates). The Economic viability and productivity of a country positively influences the value of its currency. Further, Internal, regional, and international political conditions and events have a profound effect on international currency markets. Market Psychology & market perception also have profound impact on Currency rates.