Causes of Exchange Rate Changes

Introduction

Key Concepts

1. Demand and Supply for Currencies

At the heart of exchange rate determination lies the interaction of demand and supply for different currencies in the foreign exchange market. The exchange rate is the price of one currency in terms of another and is influenced by various factors that affect this demand and supply balance.

• Demand for Currency: Influenced by factors such as trade balances, investment flows, and speculation. For instance, if a country exports more than it imports, foreign buyers need its currency to pay for the exports, increasing demand.
• Supply of Currency: Determined by a country's imports, foreign investment, and capital outflows. A higher import level means more of the country's currency is being sold to purchase foreign goods.

The equilibrium exchange rate is reached when the quantity of currency demanded equals the quantity supplied. Shifts in demand or supply can lead to appreciation or depreciation of the currency.

2. Interest Rates

Interest rates set by a country's central bank directly impact the exchange rate. Higher interest rates offer lenders a better return relative to other countries, attracting foreign capital and increasing demand for the domestic currency.

• Higher Interest Rates: Attract foreign investment, leading to currency appreciation.
• Lower Interest Rates: May result in capital outflow, causing currency depreciation.

For example, if the Bank of England raises interest rates, it may attract investors seeking higher returns, increasing demand for the British pound.

3. Inflation Rates

Inflation erodes the purchasing power of a currency. A country with lower inflation rates sees its currency appreciate relative to countries with higher inflation.

• Low Inflation: Enhances currency value as goods and services become relatively cheaper internationally.
• High Inflation: Diminishes currency value, making exports more expensive and imports cheaper.

For instance, if Japan maintains a lower inflation rate compared to the United States, the Japanese yen may appreciate against the US dollar.

4. Economic Indicators

Economic indicators such as GDP growth, unemployment rates, and industrial production influence investor perceptions and, consequently, exchange rates.

• Strong GDP Growth: Signals a robust economy, attracting foreign investment and strengthening the currency.
• High Unemployment: May indicate economic weakness, leading to currency depreciation.

For example, robust economic growth in Germany can attract investors, increasing demand for the euro.

5. Political Stability and Economic Performance

Countries with stable political environments and sound economic policies are more attractive to investors, boosting demand for their currencies.

• Political Stability: Reduces risk, encouraging foreign investment and currency appreciation.
• Political Uncertainty: Creates perceived risks, leading to capital flight and currency depreciation.

Brexit, for example, introduced political uncertainty in the UK, impacting the British pound's stability and value.

6. Speculation

Expectations about future movements in exchange rates can influence current exchange rates. If traders believe a currency will strengthen, they will buy more of it now, driving up its value.

• Positive Speculation: Anticipation of currency appreciation leads to increased demand.
• Negative Speculation: Expectations of depreciation result in selling off the currency.

For instance, if investors anticipate that the US dollar will rise due to a forthcoming interest rate hike, they may purchase more dollars, causing its value to increase.

7. Balance of Payments

A country's balance of payments encompasses its transactions with the rest of the world, including trade, investment, and financial flows. A surplus indicates that a country exports more than it imports, strengthening its currency, while a deficit can weaken it.

• Current Account Surplus: Reflects higher exports, boosting currency demand.
• Current Account Deficit: Indicates higher imports, increasing currency supply.

China's consistent current account surplus has contributed to the strength of the Chinese yuan in the global market.

8. Government Intervention

Governments and central banks may intervene in the foreign exchange market to stabilize or influence their currency's value. This can be through direct buying or selling of their currency or through monetary policies.

• Direct Intervention: Central banks buy or sell their currency to influence its value.
• Monetary Policy Adjustments: Changes in interest rates or other policies can impact exchange rates indirectly.

The Swiss National Bank's decision to cap the Swiss franc against the euro is an example of direct intervention to prevent excessive appreciation.

9. Relative Strength of Other Currencies

The strength of a nation's currency is often measured against other major currencies. The performance of trading partners and competitor economies can influence exchange rates.

• Strong Companion Currencies: If major currencies like the euro or yen strengthen, others may depreciate in comparison.
• Weak Companion Currencies: Can lead to appreciation of other currencies as relative attractiveness increases.

For example, if the euro strengthens due to economic growth in the Eurozone, other currencies like the British pound might weaken in relative terms.

10. Terms of Trade

Terms of trade refer to the ratio of export prices to import prices. Favorable terms of trade improve a country's purchasing power and can lead to currency appreciation.

• Improved Terms of Trade: Higher export prices relative to imports increase currency demand.
• Deteriorated Terms of Trade: Lower export prices relative to imports decrease currency demand.

If Australia's terms of trade improve due to higher commodity prices, the Australian dollar may appreciate as export revenues increase.

Advanced Concepts

1. Purchasing Power Parity (PPP)

Purchasing Power Parity is a theory which states that in the long run, exchange rates should adjust to equalize the price levels of a basket of goods and services between two countries. It implies that identical goods should cost the same in different countries when priced in a common currency.

The PPP can be expressed mathematically as:

Where:

• S: Spot exchange rate.
• P₁: Price level in country 1.
• P₂: Price level in country 2.

For example, if a basket of goods costs $100 in the US and €80 in the Eurozone, the PPP exchange rate would be: $$ S = \frac{100}{80} = 1.25 \, \text{USD/EUR} $$

If the actual exchange rate diverges from the PPP, arbitrageurs may engage in transactions to exploit the price differences, pushing the exchange rate towards the PPP equilibrium.

2. Interest Rate Parity (IRP)

Interest Rate Parity is a fundamental principle in international finance that links interest rates and exchange rates. It asserts that the difference in interest rates between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.

The formula for Interest Rate Parity is: $$ \frac{F}{S} = \frac{1 + r_d}{1 + r_f} $$ Where:

• F: Forward exchange rate.
• S: Spot exchange rate.
• r_d: Domestic interest rate.
• r_f: Foreign interest rate.

IRP ensures that arbitrage opportunities are eliminated by balancing the potential returns from different interest-bearing assets across countries.

For example, if the US interest rate is 5% and the UK interest rate is 3%, the forward rate should adjust so that: $$ \frac{F}{S} = \frac{1 + 0.05}{1 + 0.03} \approx 1.0194 $$

This means that the forward exchange rate will be approximately 1.94% higher than the spot rate to prevent arbitrage profits.

3. The Mundell-Fleming Model

The Mundell-Fleming Model extends the IS-LM framework to an open economy, incorporating exchange rates. It analyzes the relationship between the economy’s interest rates, exchange rates, and output under different exchange rate regimes.

The model's key components include:

• IS Curve: Represents equilibrium in the goods market.
• LM Curve: Represents equilibrium in the money market.
• BP Curve: Represents balance of payments equilibrium.

Under a fixed exchange rate regime, the central bank maintains the exchange rate by buying or selling domestic currency, affecting the money supply. In contrast, under a floating exchange rate, the exchange rate adjusts to balance the BP curve.

For example, in a floating exchange rate system, an increase in foreign interest rates may attract capital inflows, causing the domestic currency to appreciate, which then affects net exports and overall equilibrium.

4. Real Exchange Rate Equilibrium

The real exchange rate adjusts for differences in price levels between countries, providing a measure of competitiveness. It is crucial for assessing long-term equilibrium and sustainability of exchange rates.

The real exchange rate (R) is calculated as: $$ R = S \times \frac{P}{P^*} $$ Where:

• S: Nominal exchange rate.
• P: Domestic price level.
• P*: Foreign price level.

An equilibrium real exchange rate implies balanced trade flows and sustainable economic relationships. Deviations may lead to adjustments in output and employment to restore equilibrium.

For instance, if the domestic price level rises relative to the foreign price level, the real exchange rate appreciates, potentially reducing exports and increasing imports to restore balance.

5. Portfolio Balance Models

Portfolio Balance Models consider investors’ preferences for holding different types of assets, including domestic and foreign bonds. These models recognize that exchange rates are influenced by the supply and demand for a country’s financial assets.

Key aspects include:

• Asset Substitutability: Assets from different countries are not perfect substitutes, leading to interest rate differentials affecting exchange rates.
• Risk and Return: Investors balance expected returns against risks, influencing their currency holdings and thus exchange rates.

For example, if US bonds offer higher returns compared to European bonds, investors may increase demand for US dollars to purchase these bonds, appreciating the USD.

6. Behavioral Finance and Exchange Rates

Behavioral Finance explores how psychological factors and cognitive biases influence investors’ decisions, impacting exchange rate movements beyond traditional models.

Key concepts include:

• Herd Behavior: Investors may follow the actions of others, leading to rapid and sometimes irrational currency movements.
• Overreaction and Underreaction: Markets may overreact to news, causing excessive volatility, or underreact, delaying adjustments.

For instance, unexpected political events can trigger herd behavior, causing sharp and sudden movements in exchange rates as investors react en masse.

7. Exchange Rate Regimes and Their Impact

Exchange rate regimes—fixed, floating, and pegged—significantly influence how exchange rates respond to various economic factors.

• Fixed Exchange Rate: The currency's value is tied to another major currency or a basket of currencies. Requires active intervention by the central bank to maintain the peg.
• Floating Exchange Rate: The currency's value is determined by market forces without direct government or central bank intervention.
• Pegged Float: A hybrid system where the currency is allowed to fluctuate within a predetermined range around a fixed rate.

Each regime affects how shocks to the economy—such as changes in interest rates or inflation—translate into exchange rate movements. For example, under a fixed regime, monetary policy is constrained by the need to maintain the fixed rate, whereas a floating regime allows more flexibility.

8. Capital Controls

Capital controls are measures taken by governments to regulate the flow of foreign capital in and out of the domestic economy. These can include taxes, tariffs, or outright restrictions on capital movements.

• Restrictive Controls: Limit the ability of investors to move capital, which can stabilize exchange rates but may deter foreign investment.
• Liberal Controls: Facilitate easier capital flows, potentially increasing exchange rate volatility due to rapid movements of funds.

For example, China has historically implemented capital controls to manage the value of the yuan, preventing excessive volatility and maintaining economic stability.

9. External Shocks

External shocks such as natural disasters, geopolitical tensions, or sudden changes in commodity prices can unpredictably influence exchange rates.

• Commodity Price Shocks: Countries dependent on exporting commodities may see their currencies fluctuate with global commodity prices.
• Geopolitical Events: Conflicts or political instability can lead to risk aversion, causing investors to move funds to safer currencies.

The sudden drop in oil prices can depreciate the currencies of oil-exporting nations like Canada and Norway, affecting their exchange rates against oil-importing countries.

10. Speculative Attacks

Speculative attacks occur when investors collectively bet against a currency, anticipating its devaluation. This can lead to a self-fulfilling prophecy where the currency’s value actually falls due to massive selling pressure.

• Triggers: Economic mismanagement, unsustainable fixed exchange rates, or loss of investor confidence.
• Consequences: Rapid depreciation, high volatility, and potential economic crises.

The 1992 Black Wednesday crisis, where the British pound was forced out of the European Exchange Rate Mechanism due to speculative pressure, exemplifies the impact of speculative attacks on exchange rates.

Comparison Table

Summary and Key Takeaways