Relationship between two currenies - Essay Example

A country can determine the price of a currency against another currency in two ways, which include fixed and floating exchange rate. Fixed or pegged exchange rate is rate of currency determined and maintained by Central Bank. “In order to maintain local exchange rate, the central bank buys and sells it own currency in the foreign exchange market in return for the currency against which it is pegged” (Mano, 2010). On the other hand, floating exchange rate is determined by market a force, which means levels of supply and demand of the currency, decides at which price the currency will be sold in foreign exchange market.

There are multifarious factors, which determine the exchange rate. This includes higher interest rate that would attract the foreign financial capital inflow in the local country and foreigners demand for local currency escalates resulting in appreciating exchange rate. Another factor is economic health, which means foreign investors are likely to invest in countries with high positive indicators like inflation growth and debt burden rather than in economies, which are weak. Exchange rate is also quite susceptible to shocks and speculation.

In addition, money markets are liquid so exchange rates are responsive to sudden shocks (Madura, 2008). Currency rates even move because of speculative investments or if brokers trade them as per their expectations of exchange rate. One other important factor is government or central bank intervention, which we already discussed under fixed exchange rate. The two major strong currencies of the world are dollar and Euros. It is not possible to conclude the exchange rate discussion without mentioning about them (Madura, 2008).

There are different theories by which economists explain the general movements in exchange rate. However, none of them is strong enough to describe the exact movements so for; therefore, they explain these movements with the term “random walk pattern”. It is impossible to overlook the exchange rate between dollar and yen when discussing reasons behind the general movements in exchange rates. This is because of the appreciating yen against dollar that has been under maintenance since last 15 years, thus, it is important to explore the root causes behind this appreciation (Madura, 2008).

Observing the exchange rate for last seven months of yen against one dollar was 85, 84, 81,82,83,82, and 83 in August to February period. Hence, on average, yen has appreciated from August 2010 to January 2011 but it bounced back against dollar on February 15, 2011 at rate of 83.7972. The foremost thing to consider when deciding on the reasons of general movements in exchange rate is that exchange rate is just the price of one currency in terms of another. If yen is strong against dollar it means it is stronger relative to dollar that is dollar is weak and yen is not strong in itself (Madura, 2008).

The major reason for weak dollar is due to its global financial crisis and most probably risk of “second dip’ which means second recession. Apart from these crises, President Obama is in a flabby situation because his mid- term congress elections are round the corner. Hence, these shaky situations are resulting in a search for “safe haven” as investors are finding yen as a stable currency as compared to dollar or euro. This results in yen appreciation (Madura, 2008). There are not only direct reasons, which result in appreciation of yen