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Factors influencing Exchange Rates
i. Inflation: Other things being equal, a country experiencing a high rate of inflation will experience a lower demand for its goods while its trading partners goods whose rate of inflation is low will now appear cheaper to citizens who will thus buy more. Thus demand for its currency will decrease while the demand for its trading partners' currencies will increase, and both the factors will cause a depreciation in the external value of its currency. If on the other hand, a domestic rate of inflation is lower than that of its trading partners these factors will be expected to work in reverse.
ii. Non-trading factors: Exchange rates re also influenced by invisible trade, interest rates, capital movement speculation and government activities.
iii. Confidence: A vital factor in determining the exchange rate is confidence that most large companies "buy forward" i.e. they buy foreign currency ahead of their needs. They are thus very sensitive to factors which may influence future acts such as inflation and government policy.
Thus, the exchange rate at any particular moment is more likely to reflect the anticipated situation on country rather than the present one.
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