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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 currency if the return (that is the interest rate) ishigh enough. In general, the higher a country's interest rates, the greater will be the demand forthat currency. It has been argued[by whom?]that such speculation can undermine real economicgrowth, in particular since large currency speculators may deliberately create downward pressureon a currency by shorting in order to force that central bank to buy their own currency to keep itstable. (When that happens, the speculator can buy the currency back after it depreciates, closeout their position, and thereby take a profit.

How is the exchange rate determined?

Theexchange ratechanges from day to day, hour to hour, even minute to minute Why is that?

Just like the market for any good, the exchange rate is determined bysupply and demand!

Lets say there are only two countries in the world: the US and the EU. There exists a marketfor US dollars in the world. There is a certain amount of dollars that Europeans want and acertain number of dollars that Americans want to make available to Europeans. The price inthis market is the nominal exchange rate if the exchange rate is high, Europeans want less(just as you would buy less apples if they were expensive), and Americans want to make moreavailable because they will get more for it (they are like the apple grower). Where supply equalsdemand we get an equilibrium exchange rate and quantity of dollars bought and sold in theforeign exchange market.
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As the demand and supply of dollars in the foreign exchange market moves around, so does the

exchange rate!

If either demand rises (shift right) or supply falls (shift back) the nominal exchange rateappreciates(e goes up)

If either demand falls (shift left) or supply rises (shift out) the nominal exchange ratedepreciates(e goes down)

What leads to changes in demand and supply?

Changes intrade

o The supply of dollars is determined by US demand for imports from the EU.

o The demand for dollars is determined by EU demand for US exports.

Example: If the EU loses interest in buying US goods, then the demand for US exportswill fall, as will the demand for US dollars in the foreign exchange market, and the dollarwill depreciate. The Europeans need fewer dollars because they are buying fewerAmerican goods.
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Speculation / foreign exchange traders

Some people buy and sell currencies to make a profit if they can buy acurrency when the exchange rate is low and sell the currency when theexchange rate is high, they will make money.

Speculators guess as to what the exchange rate will be in the future andbuy and sell according to that guess, either demanding more or lessdollars or supplying more or less dollars.

Example:If speculators think that the exchange rate of the dollar will be less next week,they will try and sell their dollars now. This increases the supply of dollars in the foreignexchange market and the dollar will depreciate.

Determining exchange rates


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There are a number of methods that can be used to determine an exchange rate:

a. A flexible or floating exchange rateis where the market forces of supply and demanddetermine the exchange rate.

b. A fixed exchange rate is where the government determines the exchange rate for a

period of time based on the value of another countrys currency such as the US dollar.c. A managed exchange rate iswhere the government intervenes in the market toinfluence the exchange rate or set the rate for short periods such as a day or week.

a.

Flexible (or floating) exchange rates

Under a flexible or floating exchange rate the value of a countrys currency changes

frequently, even by the minute. The market rate will depend on the demand for, andsupply of, that currency in the forex markets. When there is no intervention in the freemarket operations by a government agency a clean floatis said to exist.

Figure 1

The determination of the exchange rate under a floating exchange rate is shown in figure

1.

The demand curve (DD) indicates the quantity of Australian dollars that buyers (thosepeople who hold US dollars) are willing to purchase at each possible exchange rate.

The supply curve (SS) shows the quantity of Australian dollars that will be offered forsale (those people who hold Australian dollars) at each exchange rate.


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At the equilibrium exchange rate of $A1.00 = $US0.50 the equilibrium quantity suppliedand demanded is Q1 Australian dollars. At an exchange rate above equilibrium, such as$A1.00 = $US0.60, an excess supply of Australian dollars exists and market forces willforce the exchange rate down towards equilibrium.

If the exchange rate is below equilibrium, such as $A1.00 = $US0.40, an excess demandsituation exits and market forces will put upward pressure on the value of the Australiandollar.

Remember that there are many different exchange rates. The following examples

illustrate how an appreciation (increase in value) or depreciation (decrease in value)

of the Australian dollar against the US dollar has been created by changes in

demand and supply conditions.

i. A currency appreciation

Figure 2

a.

In Figure 2a there has been an increase in demand (DD to D1D1) for

Australian dollars. This has led to an increase (appreciation) in value ofthe Australian dollar from $US0.50 to $US0.60 and the quantity ofAustralian dollars traded has also increased from 0Q to 0Q1.

The shift in the demand curve could have been caused by an increase inthe demand for Australian exports, such as coal, aluminum, beef or lamb


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b. In Figure 2b there has been a decrease in the supply (SS to S1S1) ofAustralian dollars. This has led to an increase in the value (appreciation)of the Australian dollar from $US0.50 to $US0.60. However the quantityof Australian dollars traded has decreased from 0Q to 0Q1.

This decrease in the supply of Australian dollars may have been caused bya recession, slowing the demand for imports.

ii. A currency depreciation

Figure 3

a. In Figure 3a there has been a decrease in demand (DD to D1D1) forAustralian dollars. This has led to a depreciation in the value of theAustralian dollar from $US0.50 to $US0.40. The quantity of Australiandollars traded has also decreased from 0Q to 0Q1.

The decrease in the price of Australian dollars in terms of US dollarscould have been generated by a slow down in global economic activity, so

decreasing the demand for Australian exports, or because of foreigninvestors lacking confidence in the Australian economy and investingelsewhere.

b. Figure 3b indicates an increase in supply of Australian dollars with thesupply curve moving from SS to S1S1. Again the value of the Australiandollar has decreased from $US0.50 to $US0.40 while the quantity ofAustralian dollars traded has increased from 0Q to 0Q1.


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The depreciation may have resulted from strong domestic economicgrowth increasing the demand for imports, or from higher overseasinterest rates, causing a capital outflow from Australia.

b. Fixed exchange rates

The World Bank and the IMF were both established in 1944 at a conference of worldleaders in Bretton Woods, New Hampshire (USA). The aim of the two "Bretton Woodsinstitutions" as they are sometimes called, was to place the global economy on a soundfooting after World War II. To help reduce the economic instability that existed theconference favoured the use of a fixed exchange ratesystem.

Under a fixed exchange rate systemthe value of a countrys currency is fixed by thegovernment or one of its agencies, for example the Reserve Bank of Australia (RBA) toanother currency for a specific time period.

This method of determining exchange rates was to dominate until the 1970s.

In Australia the dollar was fixed (pegged) from 1946 to December 1971 to the Britishpound and then to the US dollar until September 1974.

From September 1974 to November 1976 the Federal Government, in an attempt toreduce the impact of exchange rate fluctuations on the economy pegged the Australiandollar to the trade weighted index (TWI).

Using this system the value of the Australian dollar was allowed to adjust against eachcurrency in the TWI. However in reality the value of the Australian dollar remained fixed

for long periods of time.

Click here for more on the TWI

Figure 4
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In Figure 4 the official exchange rate has been fixed at a level of $A1.00 = $US0.60,which is above the market rate of $A1.00 = $US0.50. For the exchange rate to be fixed ata level higher than the market rate requires official intervention by the Reserve Bank ofAustralia.

At this level the RBA would have to buy the excess supply of Australian dollarsequivalent to Q1Q2 at a price of $US0.60. To buy the surplus of Australian dollars thegovernment would need to sell its reserves of foreign currency.

A fixed exchange rate system does not imply that the rate will stay at that same level allthe time. The government may decide to change the rate because of adverse effects on theeconomy. For example, if the currency is overvalued exporting industries will becomeless internationally competitive, affecting international trade and the balance of paymentsand the government might take action to devalue the exchange rate.

A devaluationof a currency occurs under a fixed exchange rate system when there isdeliberateaction taken by a government to decrease its value in the forex market.

OR

Alternatively arevaluationoccurs under a fixed exchange rate system when there isdeliberateaction taken by the government to increase the value of the currency in theforex market.

c. Managed exchange rates

A managed exchange rate occurs when there is official intervention by a government oran agency such as the RBA to determination the value of a countrys exchange rate.


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Through such official interventions it is possible to manage both fixed and floatingexchange rates.

The Australia dollar was pegged to TWI from September 1974 to November 1976. Thenin November 1976, the government adopted a managed flexible pegor a crawling

peg system. Under this new method of determining exchange rates, the value of theAustralian dollar was changed relative to the TWI, not just relative to a single individualcurrency

The exchange rate was announced each morning by the RBA and remained at that rateuntil the next morning. This system continued until the Australian dollar was floated inDecember 1983.

Under the floating exchange rate system the value of the Australian dollar is notspecifically targeted by the RBA. To intervene in the market and alter the exchange ratesignificantly in the long run is beyond the financial ability of the RBA. This is because

Australias level of foreign reserves (gold and foreign currencies) are relatively small(A$34 billion) compared to volumes of currency trade in the market each day.

However the RBA may decide to enter the foreign exchange market as either a buyer orseller to stabilise any short-term fluctuation in the value of the Australian dollar. To limita fall in the value of the Australian dollar (depreciation) the RBA will buy Australiandollars, and to prevent a rise in the value of the Australian dollar, the RBA will sellAustralian dollars in the market.

Such intervention by the RBA is known as a dirty float, or more correctly amanaged float.

Review exercises

Exercise 1

The following table indicates the value of one Australian dollar in terms of New Zealand dollarsand Japanese yen over a two day period.

Currency Day 1 Day 2

Japanese yen 69.0 65.0

New Zealanddollars

1.20 1.25

i. What has happened to the value the Australian currency from day one to day two?
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Answer

ii. All other things being equal, how would a movement in the value of the Australian dollarfrom $A1.00 = $NZ1.20 to $A1.00 = $NZ1.25 affect Australian producers andconsumers?

Answer

Exercise 2

The following diagram shows a hypothetical forex market for Australian dollars.

The Federal Government for economic reasons has decided to intervene in the market andmaintain the exchange rate at $A1.00 = US$0.55.
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