I have read a number of posts on various blogs that discuss different factors that contribute to the appreciate or depreciation of a currency. Most of the times, the discussion is either on the appreciation of the Indian Rupee or the current depreciation of the US Dollar. These posts leave me unsatisfied because they fail to cover all the points, which are very important if you talk about ForEx relations. It might be possible that the blog author himself is unaware of all the forces involved. With this educational objective in mind, I’ll try to cover some important issues that need to be considered when we hold a discussion on Foreign Exchange Parity Relations. This post is for educational purposes only and all information provided is almost correct to my knowledge even though it might not be substantive, because it has been derived from the CFA Level-I Curriculum of the CFA Institute. I have tried to be comprehensive here, though it’s highly possible that I’ve failed; in case you don’t understand something, then let me know. I’ll try my best to explain.
Balance-of-payments (BOP) accounting is a method used to keep track of transactions between a country and its international trading partners.
The BOP equation is:
current account + financial account + official reserve account = 0
The current account measures the exchange of merchandise goods, the exchange of services, the exchange of investment income, and unilateral transfers (gifts to and from other nations).
The financial (capital) account measures the flow of funds for debt and equity investment into and out of the country.
Official reserve account transactions are funds held at the International Monetary Fund (IMF) in the form of gold, other foreign currencies, and special drawing rights at the IMF.
A nation’s current account balance does not measure its economic health. Running a deficit in the current account balance simply means a country imports more than it exports, and a country can do this for a long time. Countries that run current account deficits tend to run financial account surpluses so that they offset each other.
Factors affecting a nation’s currency:
Differences in income growth among nations will cause nations with the highest income growth to demand more imported goods. Heightened demand for imports will increase demand for foreign currencies, and foreign currencies will appreciate relative to the domestic currency.
Differences in inflation rates will cause the residents of the country with the highest inflation rate to demand more imported (cheaper) goods. If a country’s inflation rate is higher than its trading partner’s, the demand for the country’s currency will be low, and the currency will depreciate.
Differences in real interest rates will cause a flow of capital into those countries with the highest available real rates of interest. Therefore, there will be an increased demand for those currencies, and they will appreciate relative to countries whose available real rate of return is low.
Exchange Rate Effects
* An unanticipated shift to an expansionary monetary policy will lead to a depreciating currency.
* An unanticipated shift to a more restrictive fiscal policy will result in budget surpluses.
BOP Component Effects
* An unanticipated shift to an expansionary monetary policy will decrease interest rates leading to a deficit in the financial account and a depreciation of the domestic currency leads to a surplus in the current account.
* A change in fiscal policy to a larger budget deficit will cause the current account to move towards deficit and the financial account to move toward a surplus.
Different Kinds of Exchange Rate Systems-
A fixed exchange rate system has a set rate of exchange and is supported by giving up discretion in monetary policy. Some countries fix their exchange rates to other currencies, such as the U.S. dollar, and sacrifice independent monetary policy.
A pegged exchange rate system involves a commitment of a country to use fiscal and monetary policy to maintain the country’s exchange rate within a narrow band relative to another (stronger) currency or to a bundle of currencies. This type of system requires a country to use its monetary policy to maintain the desired exchange rate.