Determinants of Exchange rate
Some of the main determinants affecting exchange rate between the currencies of two countries are differential interest rates and differential inflation rate between the two countries. With regards to the interest rates, if in one country the market interest rates are high relative to another, then foreigners would be attracted to invest in that country since it would result to higher returns to investment relative to their own country.
Assuming that the market interest rates in Australia was higher than in Britain then British investors will be attracted to the Australian market thus injecting investment in terms of Sterling Pound in the country this will increase the supply of pounds hence the supply curve will shift downwards leading to appreciation of AUD against GBP. (Piana, 2001 & Krueger, 1983) Inflation rate on the other hand influences the exchange rate in that high inflation is generally associated with depreciation of domestic currency against foreign currency.
This notion is based on the “One price law” which postulates that the value of a good is the same all over the world thus price dynamics should also be the same thus if inflation in two countries remain the same then the exchange rate (assuming that factors affecting exchange rate are constant) then the exchange rate between two values will also remain the same (Piana, 2001 & Krueger, 1983). Therefore differential in inflation rate will lead to fluctuation of the exchange rate.
Inflation affects the purchasing power of the currency in that high inflation rate reduce the purchasing power, therefore the differential in purchasing power is thus reflected by the country with a high inflations currency depreciating against another country with a lower rate of inflation. For instance if a hamburger costs 5% more in Australia and 8% more in New Zealand than a year ago, then theoretically it follows that the AUD should have been appreciated by (8%-5%) 3% against the NZD (Bergen, n.
d. & Piana, 2001). Inflation gives rise to depreciation of the domestic currency against other countries currencies and thus makes imports expensive and exports become cheap thus can be act as a tool of correcting a deficit Balance of Payment in that due to inflationary pressures, imports will reduce while exports inverse leading to a positive net inflow of foreign reserves (Terry et al, 1988).