The floating exchange rate system is effect of various
demand and supply in an economy described below.
1) Current account balance: The trade balance is
the difference between the value of exports and imports. i.e lets says if Nepal
is exporting more than importing, then it would have a positive trade balance
with USA and that leads to the higher demand for the home currency which is
rupees. As a result the demand will translate in to appreciation of the
currency and vice versa.
2) Inflation rate: Theoretically, the rate of
change in exchange rate is equal to the difference in inflation rates
prevailing in the 2 countries. So, whenever, inflation in one country increases
relative to the other country, its currency falls down. As we can see weaker
the dollar is, weaker our rupees.
3) Interest rates : The funds will flow to that
economy where the interest rates are higher resulting in more demand for that
currency. European investors are investing in U.S market because of the fear that
euro currency will deteriorate because of the budget deficit in Greece, Spain
and Portugal that’s a good sign for us economy.
I hope this
helps u a bit in understanding a micro concept of economy, but still there are
others factors that need to be considered.
