Economics of Foreign Exchange Rates

The foreign exchange rate is the price of one currency in terms of another. Because the foreign exchange rate compares the currencies of 2 countries, the rate depends on the value of each currency and, thus, on the economies of both countries. There are 3 primary economic factors that affect the foreign exchange rate:

Although other factors can be enumerated, such as the international balance of payments, they can all be subsumed under these 3 primary economic determiners of the foreign exchange rate.

Purchasing Power Parity and Inflation

Goods and services have an intrinsic value that is commensurate with how well they satisfy the needs and wants of the people. Because goods and services are provided so that the providers can earn a profit, the quantity provided is limited by demand in the marketplace.

However, the quantity of money supplied by the government has no such restrictions. Through monetary policy, developed economies generally regulate the quantity of money to achieve specific monetary objectives, which may not be related to the needs of the economy. Sometimes governments will print money, or increase the money supply, to solve fiscal problems.

If the economy grows in size, the money supply must grow with it so that prices remain stable; otherwise, prices will decline because the quantity of goods and services will increase faster than the money supply, resulting in deflation. When the money supply increases faster than the economy, then inflation results. Hence, because goods and services have an intrinsic value and because their quantity is limited by their profitability to the suppliers, the nominal price of the goods and services is primarily determined by the quantity of money in the economy.

Hence, if one currency can buy more goods and services than an equal amount of another, then that currency will be more valuable; thus, there will be greater demand for it. This is because a basket of goods and services will have the same value no matter where it is located, so if that basket has a different nominal price in one country than in another, then the value of the 2 currencies must be different.

Since governments can change the amount of their currency, or the quantity of money, at will and at little cost, nominal prices are more dependent on the quantity of money than on the good or service itself. Governments have often resorted to printing money, or increasing the money supply, to solve fiscal problems. As the supply of the new money circulates within the economy, demand temporarily increases, but because the economy is no larger, prices of all goods and services increase proportionally to the money supply. Hence, the currency loses value with respect to the goods and services.

Gold is a prime example of something that should have the same value anywhere, since gold is an element that does not vary in quality. Even the demand for gold is fairly constant among countries, since its main use is as a store of value. Because gold is a relatively rare element that governments cannot simply create, it has the same value worldwide, and can be used as a universal currency to buy the same basket of goods and services anywhere in the world. (To simplify this discussion, we are ignoring some other factors that may account for real differences in value in different countries, such as comparative advantages.)

For instance, if an ounce of gold costs $1250 or €1000, then euros must be more valuable than United States dollars since it takes fewer euros to buy an ounce of gold. In fact, the price of a dollar in euros must be the same as the dollar price of an ounce of gold divided by the euro price of an ounce of gold.

=Price of Gold in Dollars
Price of Gold in Euros

This is the foreign exchange rate between dollars and euros, which, in this case, = 1.25. In other words, one euro can buy $1.25, and one dollar can buy €0.8. Hence:

1.25 / 1 = 1250 / 1000 = 1.25 or 1 / 1.25 = 0.80

Purchasing power parity means that if a basket of goods and services does not have the same nominal price, then the foreign exchange value of each currency must be such that the good or service will have the same value; otherwise arbitrage will eliminate any differences in real value. Exporters and importers would transport the goods from the low cost country to the high cost country until prices reflect the purchasing power parity of each currency.

Thus, Big Macs, iPads, and iPods will generally have the same value the world over – most of the differences in their currency price will generally be due to the differences in the value of the currencies (ignoring minor logistical costs and cultural differences in demand for certain products or services).

Investment Opportunities

Generally, a country that has better investment opportunities will attract international capital, which will cause its domestic currency to increase in value relative to other currencies, since the foreigners will have to exchange their currency for the investment country's currency to make their investments, increasing the demand for the investment currency, and, thus, raising its price, which is the foreign exchange rate.

Emerging markets, for instance, have attracted a considerable amount of international capital because their underdeveloped markets have a greater potential for growth. Hence, money invested in their stock markets will tend to grow more rapidly than in developed countries, where the economies are more mature. Indeed, sometimes a country retaliates against any increasing appreciation of its currency by instituting capital controls, as Brazil did by instituting a 6% tax on foreign purchases of Brazilian bonds.

Another measure of the investment opportunity differences between 2 countries is the prevailing interest rates, which are heavily influenced by the monetary policy of the central banks of each country.

For instance, consider the Japanese yen and the Australian dollar, otherwise known as the Aussie. The Bank of Japan has kept its key interest rate close to zero, while the Reserve Bank of Australia, which is Australia's central bank, has its key interest rate at 4.75% as of April 5, 2011. Hence, if the Japanese want to earn a decent return on their savings, many will exchange their yens for Aussies and save their money in banks in Australia. Indeed, even foreigners will borrow from Japanese banks to earn interest on deposits in Australian banks, which is known as the carry trade.

This is why the currency of a country will increase or decrease in value with respect to other currencies when the central bank increases or decreases its key interest rate, which is why forex traders carefully monitor the news and press releases concerning central banks.

The returns of foreign investments must also have interest rate parity with domestic investments, meaning that returns must account for any differences in the inflation rate of the 2 currencies. The return on foreign investments must compensate the investor for differences in the inflation rate of the domestic and foreign country. For instance, if the foreign country has a target inflation rate 2% higher than the domestic country, then an investor in the domestic country will demand a 2% higher return on any investment in the foreign country to compensate for the continuous depreciation of the foreign currency relative to the domestic currency.

While higher returns attract capital, increased investment risks will cause investors to flee or to stay away. Since inflation is a major investment risk, investors will avoid countries that are printing money to solve fiscal problems, such as Zimbabwe or Venezuela. Political turmoil will have a similar effect.

Sometimes investors react negatively to events that create uncertainty as to their impact on the financial markets. For instance, Japan had a major earthquake in March, 2011, that caused investors to unwind their carry trade, since it was difficult to predict how it would affect the strength of the yen. If the yen appreciated, it would reduce the returns of the carry trade. Indeed, the yen did temporarily appreciate, presumably on speculation that insurers and investors would sell foreign assets for yen to help pay for Japan's worst earthquake. However, the central banks of the G-7 countries intervened in the foreign exchange market by actively selling yen to reduce its rise against other currencies because of the turmoil.

Relative Desirability of a Country's Goods and Services

The other economic factor that determines the foreign exchange rate is the desirability of the country's goods and services compared to the other goods and services offered in the world marketplace. If a country provides superior products or superior services or at a lower cost, then foreigners will buy more from that country, thereby increasing the value of its currency.

For instance, the demand for United States dollars by Europeans would depend on how much they want the goods and services of the United States, how much they want to travel in the United States, and by how much they want to invest in the United States. It would also depend on the relative supply of Euros and United States dollars.

Government Intervention

Although economic factors generally determine the foreign exchange rate, governments will often intervene to achieve specific objectives. For instance, because Japan depends on exports, the Bank of Japan keeps interest rates lower than most countries so that its exports are price competitive.

China is another country that intervenes to keep its currency cheap by pegging the yuan to the dollar so that Chinese exporters can maintain a significant price advantage over its competitors. China can maintain the peg by purchasing United States Treasuries with its United States dollars. China, in effect, maintains the peg by helping to finance the debt of the United States.

Economics of Foreign Exchange Rates