Currency markets are one of most highly played markets. The reason why this market attracts innumerable speculators and hedgers alike is the implicit volatility. The range of factors that have a direct or indirect impact on the market is very diverse. Any meaningful study to isolate the degree and impact of any one factor has to take into consideration a specific time horizon. For simplicity of analysis, we will consider two time spans – the short and the long term. This differentiation becomes imperative since the magnitude, transfer mechanism and market reactions differ significantly in both.

 

The most pertinent factor affecting exchange rates in the short term is interest rates. This is because interest rates provide an accurate picture of the demand-supply situation in the country. Essentially, a country with a higher interest rate would witness sudden inflows of foreign capital. Assuming a relatively free flow of capital, foreign inflows would lead to an increase in demand for the domestic currency causing appreciation. A short-term fluctuation would thus be best predicted by any change in interest rates.

Another major factor that plays a part in determining the exchange rate is the fiscal policy. Government borrowing can impact inflation through an uptick in demand exerting a downward pressure on currency.

Policy makers and other players of the economy constantly react to economic disturbances to try to achieve equilibrium. The trend of the currency can be forecast by anticipating monetary and fiscal policy announcements of the central bank.

Market sentiment about the immediate future of the currency also plays a very important role in determining the near future trend.

Although, short and medium term overshooting is possible, it has been seen that economic and financial forces tend to push exchange rates to their equilibrium path in the long run. The most significant long-term factor is the sustained growth achieved by the country as evidenced by greater competitiveness, high GDP growth rate, healthy balance of payments and low current account deficit. A country with a stable political system, sound fiscal and monetary policies would inevitably see its currency appreciating over the long run.