Factors that Influence Exchange Rates

An exchange-rate between to countries is determined by demand and supply of the relevant two currencies, which is influenced by economic factors including, among many others, the flow of imports and exports, the flow of capital and relative inflation rates. One factor affecting an exchange-rate is the merchandise trade balance. By definition, the merchandise trade balance is the net difference between the value of merchandise being exported and imported into a particular country. For example, consider the exchange-rate for USD/ZAR. South Africa (SA) imports products from the U.S. To pay for them, South Africans need US Dollars; therefore, the SA companies trade SA Rand for US Dollars. On the other hand, because Americans desire SA goods, they purchase SA Rands.

The net effect is an increase in the supply of US Dollars and SA Rands. The SA demand for American goods and services contributes to the demand for US Dollars while American purchases of SA goods and services contribute to the demand of SA Rands. In this case, the net difference between SA purchases of American goods, and American purchases of SA goods, is the merchandise trade balance between the two countries. If the SA demand for American goods is higher than the American demand for SA goods, the demand for US Dollars is higher than the demand of SA Rands.

As a result the US Dollar would appreciate against the SA Rand. The flow of funds between countries to pay for stocks and bonds purchases also contributes to the exchange-rate movements. In the near term, these capital flows are greatly influenced by yield or interest differentials. This is known as interest rate parity, which holds that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Over the long run, the spot exchange adjusts to reflect the difference in interest rates between the two countries.

All else being equal, the higher the yield on SA securities compared to American securities, the more attractive SA securities are relative to American securities. An increase in SA yields would tend to raise the flow of U.S. dollars into SA securities as well as decrease the outflow of Rands to American securities. Combined, this increased flow of funds into SA would lower the value of the U.S. dollar and increase the value of the Rand, therefore, the SA to U.S. dollar ("ZARUSD") ratio, as it is represented in the forex market, would increase, hence you would need more Dollars to buy one SA Rand. The rate of inflation is another factor influencing currency exchange-rates. Inflation occurs when the rate of money growth in an economy is higher than the rate of growth in real GDP, hence more money is chasing fewer goods, and this in turn drives up the prices of these goods.

Since exchange rates are an expression of one unit of a currency in terms of another, inflation essentially changes the relative value of this relation. For example, if SA is experiencing higher inflation than US then the USD/ZAR ratio increases to represent the increased value of Dollars relative to SA Rand. Or seen in another way, one Rand will now buy less Dollars. This fact is rooted in the concept of a purchasing power parity, which holds that, over the long run, the exchange-rate adjusts to reflect the difference in price levels between countries, a given item will thus in theory have the same price in two countries adjusted by the prevailing exchange rate.