If a country exports more goods, the importing country will have a higher demand for the currency of the exporting country so as to meet its obligation. The value of the currency of the exporting country will therefore appreciate. The opposite is the case if a country imports more goods than exports.
2. Political Stability
Unsuitable political climate will make the citizens lose confidence in their currency. They would therefore wish to invest or just buy the currency of the other countries they deem to be stable. In so doing, the demand for currency of more political stable countries will appreciate as compared to those of politically unstable countries.
3. Inflation rate differential (purchasing power parity theorem)
Parity between the purchasing powers of two currencies establishes the rate of exchange between the two currencies. When inflation rate differential between two countries changes, the exchange rate also adjusts to correspond to the relative purchasing powers of the currencies.
The purchasing power theorem states that the:
% E(f) = I (h) – I (f) x 100
I (f) + 1
Where % E (f) is the percentage change in the direct quote
I (h) is the inflation rate in the home market
I (f) is the inflation rate in the foreign market.
4. Interest Rate Parity (International Fisher Effect)
This theory states that differences in interest rate in different market can cause a flow of funds from markets with low interest rate to markets with high interest rates.
The international fisher effect can be explained as follows:
%E (f) = I (h) – I (f) x 100
1+ I (f)
% E (f) = is the % change in direct quote.
I (h) = is the interest rate in the home market.
I (f) = is the interest rate in the foreign market.