What factors influence the determination of exchange rates?

Exchange rates are influenced by factors such as inflation rates, interest rates, political stability, and economic performance.

Inflation rates play a significant role in determining exchange rates. Countries with lower inflation rates exhibit a rising currency value, as their purchasing power increases relative to other currencies. This is because when a country has a consistently low inflation rate, the value of its goods and services increases. As a result, foreigners will want to buy more of these goods and services, increasing the demand for the country's currency and thus its value.

Interest rates also have a significant impact on exchange rates. When a country's interest rates rise, it attracts more foreign capital, leading to an appreciation of the country's currency. This is because higher interest rates provide lenders with a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause an increase in the exchange rate.

Political stability and economic performance are other crucial factors. Countries with less risk for political turmoil are more attractive to foreign investors, leading to an increase in foreign capital, which results in an appreciation of the exchange rate. Similarly, a country with strong economic performance attracts foreign investors. For instance, if a country's economy is growing, it means that business is booming, profits are up, and the economic outlook is positive. This attracts investment from foreign investors who want a piece of this economic success, leading to an increase in the demand for the country's currency and thus an appreciation of the exchange rate.

Lastly, the terms of trade, which is the ratio of export prices to import prices, can also influence the exchange rate. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favourably improved. This increases revenue from exports, which creates a higher demand for the country's currency and an increase in the currency's value.

In conclusion, the determination of exchange rates is a complex process influenced by various economic and political factors. Understanding these factors can help in predicting how exchange rates will change in the future.