User:Jibran Maqsood

Relationshup Between Exchange Rate and Macroeconomic Variables

Exchange Rate:

Exchange rate is simply defined as the the rate at which currency of one currency can be converted into currency of another country. Exchange Rate can also be defined as The price of a nation’s currency in terms of another currency. An exchange rate thus has two components, the domestic currency and a foreign currency, and can be quoted either directly or indirectly. In a direct quotation, the price of a unit of foreign currency is expressed in terms of the domestic currency. In an indirect quotation, the price of a unit of domestic currency is expressed in terms of the foreign currency. An exchange rate that does not have the domestic currency as one of the two currency components is known as a cross currency, or cross rate.

It is Also known as a currency quotation, the foreign exchange rate or forex rate.

Macroeconomic variables: Importance of the exchange rate cannot be denied in the modern world, because there has been international trade that helps country achieve its financial as well as economical goals. in order to achieve these goals it can be said that there is a must relationship between two countries currencies and in order to do the trade succesfully exchange rate must be positvely influencing for both the countries. exchange rate is affecting macrovariables of any economy this is the reason for its importance and why its direction, behaviour and effects must be analysed and studied in order to make the economy prosper.

Exchange Rate and Trade balance

Exchange rate has always been a driving force for the trade balance of a country.with highly unstable exchange rate, there is a slow down in the trade process because of the uncertainty about the future exchange rate and high risk.when there is a decrease in the local country's currency there is a decrease in the volume of investment.this is a case in pakistan. price of PKR is conststly going down and the investor are not interested in the investment from outside the country, hence there is capital inflow in the form of FDI and there us less volume of business in the country.even the local investors are eyeing the foreign projects to invest and earn some handsome amount of return. unstable exchange rate effect consumers and local investor in the short run whereas it affects import, export volume government sales etc in the long run. with the unstable Exchange rate there is more chances of capital outflow from the country slowing down its own economy in the run. and it will not only slow down the economy of the country but also the value of the local currency will depreciate increasing the value of the foreign currency. Imports plays a vital role in the increase if the export. when exhcange rate is lower for the domsetic country.this country will have to purchase raw material at higher prices. as a result of this the finished products that are be exported by the country will be highly priced, resulting in the reduction of demand of the products. this will cause a huge change in the volume of the exports and will affect the BOP negatively. on the other hand there is an opposite affect of the lower exhcange rate and devaluation of the currency. at lower rate products that are made domestically in the country will be available in the international market at cheaper prices.in such case there will be increase in the demand of the products increasing eports and trade volume of the country. so it can be said that it has negative association.

Exchange Rate and Interest Rate

There is found a direct relationship between interest rate and the exchange rate.whenever there is a rise in the interest rate of the home country there is am appreciation i n the value of that country. it may be illustrated as follows: an increase in the interest rate means an increase in the return on the investment.as a result of this, investors from inside and outside are attracted more to the market, in such situation foreign investors plays a very vital role in the appreciation of the currency.when they are looking for investment in the local market,they have to ask for the local currency from the FOREX market, increasing demand for the local currency. this demand causes a rise in the appreciation in the value of the currency. similarly suppose that thee is a decrease in the interest rate what will be the affect of it on a country's currency value? as mentioned earlier there is a direct relationship among exchange rate and interest rate, hence the value of the currency will be decreasing as a result of decrease in the interest rate. with the decreasing interest.investors from the local market will take their money out from the market and start looking to invest the funds in some international market to make more revenue.this result in the capital outflow from the country and an increase of supply in the Forex market devaluing the local currency.

Exchange Rate and Inflation

inflation is a very vital macroeconomic variable to be discussed and relating to the exchange rate it has much contribution to the determination of the exchange rate.there is an inverse relation between inflation and exchange rate. an increase in the inflation means an increase in the money in the hands of people or high prices of the products. high prices of the product asks the buyers to spend some more amount on the product than before.this condition is not good for international trade. if a country's products are expensive than before, the buyer country will forsake the transactions to the country and will find another source of transaction where it can buy the products at a cheaper price. this will decrease the demand of the local currency in the FOREX market and its value will start to depreciate.

regression analysis between exchange rate and inflation is 65.4% which means inflation is a very strong variable to influence the exchange rate. coefficient of determination R2 is 42.8% which means that this percent of fluctuation in the exchange rate is caused by the inflation.

Exchange Rate and GDP

gross domestic product (GDP)is the market value of all officially recognized and final goods and services produced within an economy within the period of one year.Exchange rate is affected directly by GDP of a country.with an increase in the GDP of a country there is a decrease in the devaluation of the local currency.Regression analysis is 84.4% which suggests that there is a strong relationship between fluctuation of exchange rate and GDP. Coefficient of determination is 71.1% meaning that 71.1% of the fluctuation in the exchange rate is caused by the fluctuation in the GDP.