Determination of Exchange Rates

Readers Question: What do you think are the consequences of a) stock market trade volume and prices b) raw material inventory investment on exchange rate?

I don’t think the above will have any significant impact on the exchange rate. Stock market trade volume can be highly volatile. It is possible that high volatility may be a reflection of nervousness amongst investors. If the stock market volatility is only in that country, then the exchange rate may devalue as a consequence. But, this is only a small factor in the determination of the exchange rate. It might have no impact at all.

A jump (sharp rise) in raw material inventory investment could be a forward looking indicator suggesting an economic recovery. This may bolster prospects of higher interest rates as the economic cycle picks up. Therefore, this kind of news could cause a stronger exchange rate.

However, it would depend on the many other factors affecting the exchange rate and the economy.

The main factors that influence the exchange rate are:

Short Term Factors

Interest rates. Relative interest rates are important for determining the most attractive place for investors to deposit money. If interest rates in the UK were higher than elsewhere, sterling would tend to appreciate as hot money flows into the UK

Prospects of Growth

Prospects of higher growth, indicate the likelihood of higher interest rates, this would help strengthen sterling. But, also higher growth would give investors more confidence in the general state of the UK economy. Higher growth would help reduce the large budget deficit and strengthen the UK’s credit rating. Indirectly, this can strengthen sterling.

Long Term Factors

Inflation / Long Run Competitiveness

If UK inflation is lower than our competitors, if we become more competitive, then there will be a relatively higher demand for British goods and therefore, Sterling will appreciate over time.

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Factors Influencing Exchange Rates