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Factors Affecting Foreign Exchange Rate

There are various factors that affect the demand and supply of the currencies thus affecting the exchange rate in the foreign exchange market. Few key factors are explained below:

Inflation: As inflation rises, in one country (India), the domestic goods become expensive in comparison to another (USD). This leads to more imports and a fall in exports. This will reduce demand for INR and increase the supply of INR. Similarly, demand for USD will increase and its supply will decrease. The overall impact will be depreciated of Indian Rupee.

Interest Rate: When the interest rate in one country (India) rises in comparison to another (USA), then all the individuals and firms will invest in the country where the interest rates are high. This will lead to the sale of USD and the purchase of INR. Thus, the demand for USD will fall and that of INR will rise. Similarly, Indians will invest in INR and not USD. Thus, the supply of INR will fall and supply for USD will increase. The net effect will be an appreciation of Indian currency in comparison to USD.

Income Level: If the real income in one country(US) is more than the real income of another (India), then the country with higher income will demand more goods from other countries. This will increase demand for INR and the supply of USD will also increase because more USD will be exchanged for INR. The net impact will be an appreciation of the Indian rupee.

Government Control: The government of foreign countries can influence the equilibrium exchange rate in many ways, including

  1. Affecting macro variables such as inflation, interest rates and income levels.
  2. Intervening (buying and selling currencies) in the foreign exchange markets,
  3. Imposing foreign trade barriers,
  4. Imposing foreign exchange barriers.
Expectations: The speculations and expectations in the market and the country affect the demand and the supply of the currency, which furthers the volatility in the exchange rate. Thus, the reaction to the news, and what the market expects about the future exchange rates, affects the current exchange rate. If the investors and traders feel that the rate of inflation will increase in near future, then they will assume that the value of the rupee will fall in the future (as studied in point a). Fearing this they will begin selling rupees in the markets. The combined impact of this massive sale of INR will actually result in a fall in the INR because there is no significant increase in its demand, but a continuous increase in supply. This will push the value of UD down.

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