Answer to Question #143298 in Macroeconomics for Yesha

Question

Impact of macroeconomic variables on values of currencies.

Answer 1

Inflation rate - this is increase in the general price level of goods and services in an economy. When the home inflation rate is high the home currency will lose value and vice versa. A country with lower inflation exhibits a rising currency value and vice versa.

Interest rate - home and host countries interest rates play a vital role in exchange rate determination. If inflationary pressure prevails in the country, the Central Bank will increase base lending rate to curtail the money supply among people whereas financial institutions will make borrowing expensive. For instance, if the host country fail to adjust the interest rate, this will create inequilibrium in demand and supply for money causing exchange rate to move to equilibrium. If both home and host countries decide to increase or decrease the interest rate once, there will be no effect on exchange rate due to interest rate.

Tax rate - if expenditure exceeds the revenue, the governments will finance the gap by borrowing or by printing currency notes. This make external parties who have financial dealings with home country lose confidence. If governments fail to raise finance through taxes they will go for foreign debts which together with budget deficit leads to financial imbalance which lead to exchange rate fluctuations.

Balance of payments - this is a net indicator of outflow and inflow of foreign currencies,which are caused by international trade and services. It comprises current account and financial account. Both these accounts jointly determine the foreign exchange reserves available in a country. The floating rate regime countries will not use these reserves at a time of crisis in exchange rate while countries which follow managed float will use this to regulate the exchange rate by releasing foreign currencies required from this reserve.