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Factors Affecting Exchange Rates: Interest Rates, Inflation, Growth, & Government Interven, Slides of Management Fundamentals

Mizoram University Management Fundamentals

Various factors that impact the equilibrium exchange rate, including relative interest rates, inflation rates, economic growth, global risk, and government intervention through foreign exchange intervention policies and interest rate adjustments. The document also introduces the concept of carry trade strategies and their impact on exchange rates.

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Factors That Affect the Equilibrium

Exchange Rate: Changes in Demand

Relative (short-term) interest rates.

Affects the demand for financial assets (increase demand for high

interest rate currencies).

Relative rates of inflation.

Affects the demand for real (goods) and financial assets; hence

the demand for currencies

Low inflation results in increase global demand for a country’s goods.

Low inflation results in high real returns on financial assets.

Relative economic growth rates.

Affects longer term investment flows in real capital assets (FDI)

and financial assets (stocks and bonds).

Changes in global and regional risk.

Safe Haven Effects: Foreign exchange markets seek out safe

haven countries during periods of uncertainty.

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Factors That Affect the EquilibriumExchange Rate: Changes in Demand 

Relative (short-term) interest rates

 Affects the demand for financial assets (increase demand for highinterest rate currencies). 

Relative rates of inflation. 

Affects the demand for real (goods) and financial assets; hencethe demand for currencies  Low inflation results in increase global demand for a country’s goods.  Low inflation results in high real returns on financial assets. 

Relative economic growth rates. 

Affects longer term investment flows in real capital assets (FDI)and financial assets (stocks and bonds). 

Changes in global and regional risk. 

Safe Haven Effects: Foreign exchange markets seek out safehaven countries during periods of uncertainty.

Safe Haven Effect: September 11,

Market Intervention by Central Banks  Use the model below to explain how intervention by acentral bank can respond to (1) a “weak” currencyand (2) a “strong” currency (assume it wants to offseteither condition): Supply (of a certain FX) Price Demand (for a certain FX) Quantity of FX

Factors That Affect the EquilibriumExchange Rate: Government Interest RateAdjustments  Some governments may also use interest rateadjustments to influence their currencies.  When a currency become “too weak:”  Governments might raise short term interest rates toencourage short term foreign capital inflows.  Higher interest rates make investments more attractive andincrease demand for the currency.  When a currency becomes “too strong:”  Governments might lower short term interest rates todiscourage short term foreign capital inflows.  Lower interest rates will make investments less attractive andreduce the demand for the currency.

Impact of Carry Trades onExchange Rates 

Carry trades can result in a huge amount of capital flows in andout of currencies. 

High interest rate currency will experience increase demand.  Low interest rate currency will experience increase in supply.  Combined this will result in a strengthening of the high interest ratecurrency against the low interest rate currency. 

However, when traders reverse their positions, the oppositeexchange rate effects will occur. 

When do they reverse: During periods of increasing globaluncertainty about interest rates and exchange rates. 

For a case which combines carry trade and governmentintervention, please see: Case Study: New Zealand Central BankIntervention in the Foreign Exchange Market, June 11, 2007(posted on course web site).