B6 39 a factors influencing exchange rates

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B6- 39 A. Factors Influencing Exchange Rates Circumstances that give rise to changes in exchange rates are generally divided between trade-related factors (including differences in inflation, income, and government regulation) and financial factors (including differences in interest rates and restrictions on capital movements between companies). 1. Trade Factor— Relative Inflation Rates When domestic inflation exceeds foreign inflation, holders of domestic currency are motivated to purchase foreign currency to maintain the purchasing power of their money. The increase in demand for foreign currency forces the value of the foreign currency to rise in relation to the domestic currency, thereby changing the rate of exchange from domestic to foreign currency. E X A M P L E Assume that the U.S. dollar is relatively stable while the Mexican peso is suffering from sudden inflationary pressures. As the Mexican peso buys less in the domestic Mexican economy, Mexicans and their banking institutions seek the safe haven of the U.S. dollar to maintain the purchasing power of their liquid resources. The demand for U.S. dollars created by Mexicans buying them with Mexican pesos makes the U.S. dollar more valuable in terms of the peso and drives up the exchange rate. The U.S. dollar commands more pesos in an exchange of currency. 2. Trade Factor— Relative Income Levels As income increases in one country relative to another, exchange rates change as a result of increased demand for foreign currencies in the country where income is increasing. E X A M P L E The income level in the United States increases significantly in the second quarter. Americans flock to Mexico City on vacation to buy piñatas. The increased supply of American dollars seeking to buy pesos to purchase Mexican goods causes the value of the American dollar to fall in relation to a stated number of pesos. The exchange rate is thus impacted by relative income levels and the associated demand for foreign currency created by new domestic income. 3. Trade Factor— Government Controls Various trade and exchange barriers that artificially suppress the natural forces of supply and demand impact exchange rates. E X A M P L E A tariff on imported piñatas would have the impact of discouraging the purchase of imports, thereby reducing demand for the peso and maintaining the exchange rate. 4. Financial Factors— Relative Interest Rates and Capital Flows Interest rates create demand for currencies by motivating either domestic or foreign investments. The forces of supply and demand create changes in the exchange rate as investors seek fixed returns. The effect of interest rates is directly impacted by the volume of capital that is allowed to flow between countries.
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B6- 40 © 2012 DeVry/Becker Educational Development Corp. All rights reserved.
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