Economic Factors
Exchange rates can be impacted by economic factors. Above is given the example of Philippines and United States of America. Assume that the interest rate in US rises. This will attract foreign investors to deposit their money in US banks. This increase in demand for USD will raise the value of USD. It will depreciate the exchange rate for Peso. On the other hand, if the interest rates in US falls, it will have an opposite effect on the exchange rate for Peso. When US interest rate falls, the investors will take their money out of US and deposit it in different countries. This will decrease the demand for USD and increase the supply. With an increase in the supply of USD, there will be appreciation of USD. This will appreciate the exchange rate for Peso. When inflation occurs in the USA, the price of US goods will rise and there will be less export because the higher priced goods will result in less demand from other countries. To counter this, Philippines will receive fewer US goods and there will be less demand for USD. This decrease in demand will depreciate the exchange rate for USD. On the other hand, if there is inflation in the USA, the price of US goods will rise and there will be less import from Philippines. This will decrease the supply of USD and increase the supply of peso. This will appreciate the exchange rate for USD.
Inflation rate
Often, people mistake high exchange rates as being beneficial. They feel that more peso to a dollar means a strong economy. But it actually results in a decrease in the international competitiveness of the goods and services produced in that country. Increased inflation is the primary cause of this.
An increase in inflation will cause depreciation in the value of the local currency. When the PHP depreciates, we need more peso to buy a dollar. This directly affects businesses with foreign firms importing goods and services, as they would have to spend more. For example, if the spot exchange of SGD to PHP is 32,000:1 and the rate of inflation in the Philippines is 5% per annum, the expected exchange rate is 33,600:1. Then, S$1 will change from PHP$32 to PHP$33.60. This means that it is more costly for the Singapore firm to import goods from the Philippines, and Philippine firms will find it hard to sell goods in the export market.
Inflation rate refers to the general rise in prices of goods and services over a period of time. When the inflation rate is high, the purchasing power of consumers declines. This results in a decline in the international competitiveness of the products, thereby decreasing economic growth. High inflation brings uncertainty to an economy, and variable inflation rates impose a cost on an economy. During times of high inflation, it is difficult for businesses to make long-term plans because the value of money becomes highly unpredictable
Government policies
At the opposite spectrum to the aforementioned scenario, government policies to decrease inflation rates can create increased speculation in the PHP, which can drive up the exchange rate. This would be a possible knock-on effect from the initially mentioned increased interest rates on PHP financial assets.
One area where exchange rates are affected is the expectations of future government policy. For example, people may speculate that the current government is looking to increase the inflation rate in the future to help erode a budget deficit. This would have a negative effect on the exchange rate as people will sell off their financial assets to get higher returns elsewhere. This would be because the reduced value of the currency would erode any gains made on said asset. And if falling returns were to come from government bonds, it is possible that foreign investors would seek higher returns on investments in other countries to offset the inflation loss and possible future losses from government bond yields.
Economic factors, such as government policies, can be positive for the exchange rate. An increase in government spending can help boost economic growth. The actual act of spending money (especially if borrowed) will put increased pressure on interest rates. If the central bank were to increase interest rates, it would attract foreign capital and therefore increase the exchange rate. This is because foreign investors will get greater returns on investments in PHP financial assets
Interest rates
With the speculation of foreign investors, it will cause an increase in the value of the country’s currency. It is because higher interest rates provide a higher rate of return to those involved in the money market. This involves buying a particular currency, asset such as a bond or stock at a low price to sell it when the value rises to gain a profit. If the speculation is correct and the value of the currency rises, they will obtain more money in comparison to the amount they had bought the same amount of the currency. This will cause an increase in the demand for the country’s currency and at the same time, speculators will have to buy the currency now at a higher rate. This will lead the currency to appreciate, causing a rightward shift in the currency. Higher interest rates may continue to cause the appreciation of the country’s exchange rate until or equal to the point of the new equilibrium. At a higher exchange rate, it will now cost more units of the foreign currency to buy the same unit of the local currency.
When the interest rates of a country rise, it will cause a great impact on the value of the country’s currency. When the central bank increases the interest rates, it will carry a higher opportunity cost in comparison to other countries. The higher interest rate provides lenders in an economy a higher return relative to other countries. It will attract financial capital from the foreign exchange market. For example, if the United States interest rates raise higher than the interest rates in Britain, it will attract a return for US financial assets by foreign investors.
