Determination of Exchange Rate

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    Aside from factors such asinterest ratesandinflation,theexchange rateis oneof the most important determinants of a country's relative level of economichealth. Exchange rates play a vital role in a country's level of trade, which iscritical to most every free market economy in the world. For this reason,

    exchange rates are among the most watched, analyzed and governmentallymanipulated economic measures. But exchange rates matter on a smaller scaleas well: they impact the real return of an investor's portfolio. Here we look atsome of the major forces behind exchange rate movements.

    Overview

    Before we look at these forces, we should sketch out how exchange ratemovements affect a nation's trading relationships with other nations. A highercurrency makes a country'sexportsmore expensive andimportscheaper inforeign markets; a lower currency makes a country's exports cheaper and itsimports more expensive in foreign markets. A higher exchange rate can beexpected to lower the country'sbalance of trade,while a lower exchange ratewould increase it.

    Determinants of Exchange RatesNumerous factors determine exchange rates, and all are related to the tradingrelationship between two countries. Remember, exchange rates are relative, andare expressed as a comparison of thecurrenciesof two countries. The followingare some of the principal determinants of the exchange rate between two

    countries. Note that these factors are in no particular order; like many aspects ofeconomics,the relative importance of these factors is subject to much debate.

    1. Differentials in Inflation

    As a general rule, a country with a consistently lower inflation rate exhibits arising currency value, as its purchasing power increases relative to othercurrencies. During the last half of the twentieth century, the countries with lowinflation included Japan, Germany and Switzerland, while the U.S. and Canadaachieved low inflation only later. Those countries with higher inflation typically

    see depreciation in their currency in relation to the currencies of their tradingpartners. This is also usually accompanied by higher interest rates. (To learnmore, seeCost-Push Inflation Versus Demand-Pull Inflation.)

    2. Differentials in Interest Rates

    Interest rates, inflation and exchange rates are all highly correlated. Bymanipulating interest rates,central banksexert influence over both inflation and

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    exchange rates, and changing interest rates impact inflation and currency values.Higher interest rates offer lenders in an economy a higher return relative toother countries. Therefore, higher interest rates attract foreign capital and causethe exchange rate to rise. The impact of higher interest rates is mitigated,

    however, if inflation in the country is much higher than in others, or ifadditional factors serve to drive the currency down. The opposite relationshipexists for decreasing interest rates - that is, lower interest rates tend to decreaseexchange rates. (For further reading, seeWhat Is Fiscal Policy?)

    3. Current-Account Deficits

    Thecurrent accountis the balance of trade between a country and its tradingpartners, reflecting all payments between countries for goods, services, interestand dividends. Adeficitin the current account shows the country is spendingmore on foreign trade than it is earning, and that it is borrowing capital fromforeign sources to make up the deficit. In other words, the country requires moreforeign currency than it receives through sales of exports, and it supplies moreof its own currency than foreigners demand for its products. The excess demandfor foreign currency lowers the country's exchange rate until domestic goodsand services are cheap enough for foreigners, and foreign assets are tooexpensive to generate sales for domestic interests. (For more, seeUnderstandingThe Current Account In The Balance Of Payments.)

    4. Public Debt

    Countries will engage in large-scale deficit financing to pay for public sectorprojects and governmental funding. While such activity stimulates the domesticeconomy, nations with large public deficits and debts are less attractive toforeign investors. The reason? A large debt encourages inflation, and if inflationis high, the debt will be serviced and ultimately paid off with cheaper realdollars in the future.

    In the worst case scenario, a government may print money to pay part of a largedebt, but increasing the money supply inevitably causes inflation. Moreover, if a

    government is not able to service its deficit through domestic means (sellingdomesticbonds,increasing the money supply), then it must increase the supplyof securities for sale to foreigners, thereby lowering their prices. Finally, a largedebt may prove worrisome to foreigners if they believe the country risksdefaultingon its obligations. Foreigners will be less willing to own securitiesdenominated in that currency if the risk of default is great. For this reason, thecountry's debt rating (as determined by Moody's orStandard & Poor's,for

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    example) is a crucial determinant of its exchange rate.

    5. Terms of Trade

    A ratio comparing export prices to import prices, the terms of trade is related to

    current accounts and thebalance of payments.If the price of a country's exportsrises by a greater rate than that of its imports, its terms of trade have favorablyimproved. Increasing terms of trade shows greater demand for the country'sexports. This, in turn, results in rising revenues from exports, which providesincreased demand for the country's currency (and an increase in the currency'svalue). If the price of exports rises by a smaller rate than that of its imports, thecurrency's value will decrease in relation to its trading partners.

    6. Political Stability and Economic Performance

    Foreign investors inevitably seek out stable countries with strong economicperformance in which to invest their capital. A country with such positiveattributes will draw investment funds away from other countries perceived tohave more political and economic risk. Political turmoil, for example, can causea loss of confidence in a currency and a movement of capital to the currencies ofmore stable countries.

    ConclusionThe exchange rate of the currency in which a portfolio holds the bulk of itsinvestments determines that portfolio's real return. A declining exchange rateobviously decreases the purchasing power of income andcapital gainsderivedfrom any returns. Moreover, the exchange rate influences other income factorssuch as interest rates, inflation and even capital gains from domestic securities.While exchange rates are determined by numerous complex factors that oftenleave even the most experienced economists flummoxed, investors should stillhave some understanding of how currency values and exchange rates play animportant role in the rate of return on their investments.

    What Determines Exchange Rates:

    If I visit an exchange rate site such asXE.com,it will tell me that 1 U.S. dollar is trading for 0.67

    euros. But how is this exchange rate determined? What gives the U.S. dollar this value when priced in

    euros?

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    Short Run Exchange Rates are Determined by Supply andDemand:

    Like any other price in our economy, exchange rates are determined by supply and demand -

    specifically the supply and demand for each currency. But that explanation is almost tautological - we

    need to know what determines the supply of a currency and the demand for a currency.

    What Determines the Demand for a Currency?:

    The supply of a currency on a foreign exchange market is determined by the following:

    Demand for goods, services and investments priced in that currency. If I want to buyCanadian bonds or Canadian maple syrup, then I will need Canadian dollars to do so. If totalexpenditures, by non-Canadians, on these items rise, the demand for the Canadian dollar willrise.

    Speculators. If I believe, for whatever reason, the Canadian dollar will rise in value in the

    future, I will want to buy more Canadian dollars today.

    Central banks - Occasionally central banks will buy up a foreign currency to affect theexchange rate.

    What Determines the Supply of a Currency?:

    The supply of currency is affected by the following:

    Demand for goods, services and investments priced in a differentcurrency. If I wantCanadian maple syrup, I will need Canadian dollars. To get Canadian dollars, I will have tosupply a currency in return, such as yen or U.S. dollars.

    Speculators. If I believe, for whatever reason, the Canadian dollar will fall in value in thefuture, I will start to sell off my Canadian dollars today (that is, supply them to the market).

    Central banks through increases in the money supply. See:Why Not Just Print More Money?

    What Should The Currency Be Worth?:

    If speculators can affect both the supply and demand for a currency, they can ultimately affect the

    price. Thus does a currency have an intrisic value relative to another currency? Is there a level the

    exchange rate should be at?

    It turns out there is at least a rough level to which a currency should be worth - please seeABeginner's Guide to Purchasing Power Parity Theory.The exchange rate, in the long run, needs to be

    at the level which a basket of goods costs the same in two currencies. Thus if a Mickey Mantle rookie

    card costs $50,000 Canadian and $25,000 US, the exchange rate should be 2 CDN = 1 US.

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    Fluctuations in exchange rates[edit]

    A market-based exchange rate will change whenever the values of either of the two componentcurrencies change. A currency will tend to become more valuable whenever demand for it isgreater than the available supply. It will become less valuable whenever demand is less than

    available supply (this does not mean people no longer want money, it just means they preferholding their wealth in some other form, possibly another currency).[7]

    Increased demand for a currency can be due to either an increased transactiondemand for moneyor an increased speculative demand for money. The transaction demand is highly correlated to acountry's level of business activity, gross domestic product (GDP), and employment levels. Themore people that areunemployed,the less the public as a whole will spend on goods andservices.Central bankstypically have little difficulty adjusting the available money supply toaccommodate changes in the demand for money due to business transactions.

    Speculative demand is much harder for central banks to accommodate, which they influence by

    adjustinginterest rates.A speculator may buy a curr...