How are exchange rates determined? This is one of the most fundamental and complex questions in economics. And as of today, it has NOT yet been fully solved.
That being said, economists have a pretty good understanding of the basic variables that determine the exchange rate: inflation and interest rates. The biggest problems are that they do not know which of these variables is dominant for each country and at each point in time and how they interact with each other and the exchange rate.
While that may be, to understand whether exchange rates will go up or down, you will still need to understand the basic economics of exchange rates.
In this blog, I am going to tell you all about exchange rates so that, by the end of it, you will not only understand the basic economic variables that determine exchange rates but also why it is still so difficult to predict exchange rate movements.
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Alright, let’s start with the basics.
The exchange rate is the price of one currency … expressed in that of another currency. This means that it can be expressed in two ways.
For example, you can say that since a South African Rand gets you 0.056 Euro, the Rand/Euro exchange rate is 0.056. Or you can say that, since 1 Euro gets you 17.88 Rand, the Euro/Rand exchange rate = 17.88.
Luckily, there is a standard for this and that is that people should express the exchange rate such that it indicates how much foreign currency they can buy with their home currency. To avoid confusion, in this post, I will always talk about the price of a currency and about a currency appreciation if its price will increase compared to other currencies and deprecation if its price will decrease.
What determines the exchange rate?
So with the basics out of the way, how is the exchange rate between two currencies determined?
The simple answer is that it is determined by supply and demand on foreign exchange markets.
Foreign exchange markets are decentralised, meaning that currencies are exchanged all over the world, on electronic exchanges and via market-makers. This market is largely hidden from consumers and businesses, since they typically go to their bank, which will then visit the foreign exchange market for them.
But, even though these markets are somewhat hidden, prices are determined, like in all other markets, by supply and demand. If demand for a currency goes up .. the price of that currency will go up, so you’ll have to use less of one currency to obtain other currencies. In other words, that currency appreciates. On the other hand, if there is more supply of a currency, than the price of that currency will go down, meaning that the currency depreciates.
So, there you have it, exchange rates are determined by supply and demand… Easy… but kind-off useless on its own because that leaves us with the question…. What drives supply and demand for currencies?
On this, economists agree that a big chunk of currency supply and demand comes from traders trying to make a buck from differences in prices between countries. The practice of trying to make a quick buck from price differences, is formally known as arbitrage. And traders who participate in it are known as arbitrageurs. Now you might ask, how can some trader, possibly you, profit from price differences between countries?
This is where the two most prominent theories of the exchange rate come in.
You see, a currency is a tricky thing to price because it is money.
And money has three major functions: it is a medium of exchange, a unit of account, and a store of value.
Now, the first major theory of what determines the exchange rate focusses on the first two aspects: medium of exchange and unit of account. Purchasing power parity theory.
This theory is known as the Purchasing Power Parity theory. The main idea of purchasing power parity is that prices in two countries should roughly be the same. If they are not, that means that arbitrageurs can come in and make a bit of quick and easy money.
For example, say that the price of the Euro is 1:1 with the Dollar. Now, you notice that on average prices in the United States are only 80% of what they are in Europe. Being a savvy trader, you might try to buy as many goods as possible from Amazon in the U.S. and sell that in Europe at prices which are up to 20 % higher, and make a neat profit. When this happens, Europeans will start buying goods from you, and they will need Dollars to do so. So, their banks enter the FX market, offer Euro’s and obtain Dollars to pay for your goods. This drives the Euro down, and trying to buy dollars, will drive its price up. Therefore, the Euro will depreciate and the Dollar will appreciate until this arbitrage opportunity is gone.
Now, in practice there is only limited scientific evidence to back up this theory, especially when it comes to monthly exchange rate fluctuations. That being said, if there is hyper-inflation in one country, there is considerable evidence that the exchange will adjust accordingly. Also, in the long run, there is some evidence that the exchange rate adjusts to offset inflation.
But, why doesn’t purchasing power parity predict exchange rates completely? Some of the reasons are: (1) arbitrage through trade is not easy, (2) there are trade barriers between countries, and (3) not all goods can be traded and most services can certainly not be traded.
so, while economist agree that inflation and trade in goods and services are important variables in foreign exchange markets, a complementary theory was needed.
Interest rate parity theory
This second major theory of what determines the exchange rate focusses on the last aspect of money, and that is its role as a store of value. After all, what money is traded in FX markets? Is it notes and coins? No, it is bank deposits, and bank deposits typically will earn you a little bit of interest. So what happens if you can earn more interest in another country than in your own?
This is again where the smart trader might hope to make a quick buck.
Say that you are in Japan, where interest rates are close to zero. Perhaps you look south, and there you find the beautiful islands of Indonesia, the land of higher interest rates. Let’s again say, just for the sake of this example, that the Japanese Yen to Indonesian Rupiah exchange rate is 1. Well, in that case a smart Japanese trader might consider borrowing in Japan for 0% interest rate and investing that money in Indonesia for an inflation adjusted rate of roughly 8%.
Free money, right? Well…. It might be for the first traders who do this.
But, as more and more do it, this will increase demand for Rupiah, and increase the supply of Yen. So much so, that at a certain point, the Rupiah is so expensive that the 8% interest rate in Rupiah… will effectively be a 0% interest rate for new the Japanese investors.
But, again, here there are a lot of complications. For example, there isn’t just one interest rate… you could also buy a currency and use that to invest in something else than a bank deposit. For example, the local stock or housing market, here you can perhaps earn a higher dividend or rent than you could at home. Or to make it even trickier, you could earn a higher return if there is a house price boom there… Or you could profit from the Rupiah currency appreciation itself. Finally, you might be able to hedge some of that exchange rate risk, right?
As you can see, these two theories are not complete. Nevertheless, I consider them as building blocks that help me understand exchange rate movements. Indeed, the consensus seems to be among economists that in one way or another interest rates and other financial returns can help explain exchange rate movements in the short-term.
Why economists cannot, yet… predict the exchange rate.
Now, even then, you might think, okay okay only two basic theories, interest rates for the short term and inflation for the long term, I got this. Expectations
But, before you think about opening that FX trading account, I just want to point out … that in these markets you will not be the only one trying to predict the exchange rate. Besides, arbitrageurs, a lot of supply and demand in the FX market actually comes from speculators, who are trying to guess what the arbitrageurs are going to do. After all, if you can predict interest rate differentials or inflation changes, you might be able to buy the currency before the arbitrageurs … and make a quick buck by selling to them in the process. But, because lots of people are already doing this, the exchange rate likely already reflects the expectations of other traders about future interest rates and inflation… in both countries.
So, let’s do a quick recap. The exchange rate is the price of two currencies.
It can be expressed in two ways, but the most common one is to divide your home currency / by the foreign currency. The easiest way to avoid confusion, when talking about exchange rates is simply to mention if a currency appreciated or depreciated. Exchange rate movements are driven by supply and demand, which is in turn determined by the actions of arbitrageurs and speculators. Arbitrageurs will try to profit from inflation and interest rate differences between countries. However, because of speculators, a lot of expectations about these variables are likely already reflected in the exchange rate. So, if you want to enter this market … you’d better be good.
In spite of that bleak message, I believe there is still an opportunity here to invent new theories, since there is still a lot unknown about the exchange rate. For example, you now know that inflation and interest rates influence exchanges rates. But, did you know that exchange rates also influence inflation and interest rates… Also, while currency traders are smart, they are still human, they have all sorts of biases just like the rest of us that you might be able to exploit if you learn behavioural finance.
For all of that and more, consider subscribing to the Money & Macro channel, because that is what we are all about here.