At most basic level, exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another. But it explains in a superficial sense. This simple explanation doesn’t tell us what factors underlie the demand for and supply of a currency. Some fundamental factors, such as inflation, productivity, interest rates, and government policies are quite important in explaining both short-term and long-term fluctuations of a currency value.
II. Fundamental Factors To Forecast Exchange Rates
a. Inflation a) The law of one price states that in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries must be sold for the same price when their prices are expressed in terms of the same currency, for example, if $ 1 = FFr 5, then, a jacket sold for $ 50 in NY should be sold for FFr 250 in Paris. If the law of one price were true for all goods and services, the PPP exchange rate would be found from any individual set of price. So, by comparing the prices of identical products in different currencies, it would be possible to determine the “real” or “PPP” exchange rate. For instance, it takes $1 to buy one dozen of apples in NY and 2.5 DM to buy the same apples in Frankfurt, so the exchange rate between US dollars and DM is $ 1 = DM 2.5. If prices of apples double in NY while the prices in Frankfurt remain the same, then, the purchasing power of a dollar in NY drop 50 percent. Consequently, the exchange rate is $ 1 = DM 1.25.
a. Inflation b) The currency exchange rate is determined by the ratio and change of their respective purchasing powers in each country. This is called purchasing power parity theory. When the inflation rate differential between 2 countries, the exchange rate also adjust to correspond to the relative purchasing powers of the countries. That is, Domestic inflation value of domestic currency (compared with foreign countries) (compared with that of foreign country)
b. Productivity If one country becomes more productive than other countries, businesses in that country can lower the prices (costs) of domestic goods relative to foreign goods. As a result, the foreign demand for domestic goods rises, and the domestic currency tends to appreciate against foreign currency. If its productivity lags behind that of other countries, its goods become relatively more expensive and less foreign demand for those goods, and the currency tends to depreciate. So, in the long run, as a country becomes more productive relative to other countries, its currency will appreciate.
c. Interest Rate Investment capital flows in the direction of higher yield for a given level of risk. Hence, if investors can earn 6% interest rate per year domestically and 10 % in country X, they will prefer to invest in country X, provided the inflation rate and risk are the same in both countries. It causes more demands for country X’s currency, so the country X’s currency will appreciate against domestic currency. The interplay between interest rates and exchange rates is called interest rate parity theory.
d. Government Policies Monetary and fiscal policies also affect the currency value in foreign exchange markets. Expansionary monetary policy and excessive government spendings are prime causes of inflation, and continue use of such policies eventually reduce the value of the country’s currency. (Supplements: Adjustments of government spendings:) i) increase of government spending increase of production and income consumers buy more (when consumers receive extra income from increasing production) stimulates economy price level inflation; ii) spendings cutbacks reduce production and income levels consumption falls (as consumers’ income decline with decline in production levels.) price level deflation.
e. Other Factors a) An extended stock market rally in a country attracts investment capital from other countries, thus creating a huge demand by foreigners for that country’s currency. This increase demand is expected to increase the value of that country’s currency; b) A significant drop in demand for a country’s principal exports worldwide is expected to result in a corresponding decline in the value of its currency; c) A political turmoil in a country often drives capital out of the country into stable countries. A mass outflow of capital due to fear of political risk, undermines the value of a country’s currency in the foreign exchange markets.
Notes Although there is a wide variety of factors that can influence exchange rates, all of these variables will not influence the currency to the same degree. Some factors may have an overriding influence on the currency’s value, while others have less influences.