There are several ways how foreign or national currency signs can be used for the international settlements. In general, currency can be employed for different purposes:
1) To purchase or sell objects
2) As a settlement (payment) tool
3) As a credit facility
4) As a measure of the price
5) As a commercial hedging tool
Any changes in demand or supply affect exchange rates. A certain role of the currency can be realized through the international currency settlements. There are several solid factors that modify supply or demand of currency:
1. Changing the other party’s needs and tastes. Changes of consumer needs and tastes in currencies will affect a supply or demand side. When a demand for Japan’s Yen increases it also raises the exchange rate, on the other hand having increased the supply of Japan’s Yen has a negative effect on the exchange rate.
2. The relative change of income. If U.S. gross domestic product grows faster than Japan’s, then USA’s exchange rate falls relatively. Consumers in U.S. will have higher income due to the increased GDP and this will enhance their buying power for U.S. and imported products. Due to the rise of demand, Jen’s exchange rate will also increase. For this reason, Jen’s exchange price in dollars will become higher, and this will lead to devaluation of USD.
3. The relative change of prices. Let’s assume that price level in U.S. grows rapidly, however, in UK stays unchanged. Consequently, consumers from U.S. will start buying relatively cheaper products from UK. This leads to an increased demand of U.S. dollar as well as to higher exchange rate. Naturally, consumers from USA will have lower intentions to buy production from UK. That will reduce the supply of USD and depreciate U.S. dollar comparing to GBP.
4. Speculation. If we consider that U.S. economy grows faster than UK’s definitely it will lead to a higher inflation or lower real interest rates in U.S. Let’s assume we have done such an economic forecast and expect that in the future dollar’s value will fall, however exchange rates will rise. Though, investors will start to exchange U.S. dollars to another currency. Definitely, the value of U.S. dollar will start to fall down even more resulting in devaluation of U.S. dollar to the extent speculators might think.
5. The relative change of interest rates. Let’s suppose that real interest rate in U.S. is higher compared to that in other countries because U.S manages saving monetary policy. Due to this fact U.S. will be more attractive to potential equity investors as a result it will increase a demand for the financial assets of the country.