Factors Influencing Exchange Rate – Demand & Supply Forces
Why does the Rupee fall to 84 one day and rise to 82 the next? There are fundamental economic forces at play.
1. Key Factors
A. Inflation Rates (Purchasing Power Parity)
- Theory: Country with Higher Inflation will see its currency Depreciate.
- Logic: If prices in India rise by 10% and US by 2%, Indian goods become expensive. Exports fall. Demand for Rupee falls. Rupee depreciates.
B. Interest Rates (Interest Rate Parity)
- Theory: Country with Higher Interest Rates will see its currency Appreciate (in the short run).
- Logic: If India offers 7% interest and US offers 2%, global investors will move money to India (FPI inflow). Demand for Rupee rises.
C. Income Levels (GDP Growth)
- Effect: Higher Growth = Higher Imports.
- Result: If Indians become richer, they buy more iPhones (Imports). Demand for Dollar rises. Rupee Depreciates.
D. Speculation & Market Sentiment
- If traders believe Rupee will fall, they sell Rupee today. This self-fulfilling prophecy causes Rupee to fall immediately.
2. Diagram: Factor Impact Matrix
Loading comparison…
3. Exam Notes: Writing the Answer
Question: "Discuss the factors influencing Exchange Rates." (10 Marks)
Answering Strategy:
- Structure: Use headings (Inflation, Interest, Income).
- Direction: Clearly state if the factor causes Appreciation or Depreciation.
- Examples: "If US Federal Reserve raises rates, money flows out of India, causing Rupee depreciation."
Summary
- Long Term: Inflation is the main driver (PPP Theory).
- Short Term: Interest Rates and News are the main drivers.
Quiz Time! 🎯
Loading quiz…