What Determines Exchange Rates?

Readers Questions – Explain how exchange rates are determined ? (20)

Exchange Rates are determined by supply and demand side factors. For example, Increased demand for sterling will cause an appreciation in the Sterling exchange rate. These are some of the most significant factors in exchange rate determination:

sterling

 

1. Interest Rates.

If interest rates increase in the US then it becomes relatively more attractive to save money in US banks and in US bonds. Therefore, there is higher demand for US dollars (to be able to buy the securities). This causes an appreciation. – It is known as hot money flows.

2. Relative inflation Rates.

If US inflation was to become higher than other countries, US goods would become less competitive. Therefore, there would be less demand for US goods and US dollars, causing a depreciation.  General productivity and competitiveness will also have an influence on the exchange rate.

3. Balance of Payments.

If a country has a large current account deficit it means it is importing more goods and services than it is exporting.  This means more foreign exchange is leaving the country than going in. Therefore, (assuming it has difficulties in attracting a surplus on the financial account) a large current account deficits will usually cause a depreciation.

4. Speculative buying.

Foreign currencies are heavily traded and some investment banks try to make profit from buying and selling. If investors lose confidence in an economy and therefore the currency, the exchange rate will fall. This can depend on political as well as economic factors. At times currency movements can be unpredictable to say the least.

 

Example Fall in Value of Sterling 2007 – Jan 2009

 

sterling eri

During this period, the value of Sterling fell over 20%. This was due to:

  • Restoring UK’s lost competitiveness. UK had large current account deficit in 2007
  • Recession hit UK economy hard. Markets expected interest rates to stay low for a considerable time.
  • Bank of England pursued quantitative easing (increasing money supply). This raises prospect of future inflation, making UK bonds less attractive