13.2 Determinants of exchange rates

Exchange rates are the lifeblood of international trade and finance. They determine the value of one currency relative to another, influencing everything from trade balances to investment flows. Understanding what drives exchange rates is crucial for businesses and policymakers alike.

This topic dives into the key factors that shape exchange rates. From economic fundamentals like growth and inflation to market sentiment and speculation, we'll explore how these forces interact to move currencies. We'll also look at theories like purchasing power parity that explain long-term exchange rate trends.

Exchange rate movements

Factors influencing exchange rates

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• Supply and demand for different currencies in the foreign exchange market drive exchange rate movements
• Appreciation or depreciation of a currency relative to another results from the interaction of supply and demand forces
• Macroeconomic fundamentals (economic growth, inflation, trade balances) shape exchange rate dynamics
  • Countries with strong economic prospects and low inflation typically experience currency appreciation
• Monetary policy decisions by central banks, particularly interest rate changes, significantly impact exchange rates
  • Higher interest rates attract foreign capital, increasing demand for the domestic currency and potential appreciation
• Political stability and geopolitical events influence investor confidence and risk perception, affecting capital flows and exchange rates
  • Political uncertainties or instability may lead to currency depreciation (Brexit, trade tensions)

Short-term fluctuations and market sentiment

• Speculative activities and market sentiment create short-term fluctuations in exchange rates
  • Speculators buy or sell currencies based on expectations of future price movements
  • Speculative activities can amplify or reverse currency trends (carry trades, momentum trading)
• News events and data releases (GDP reports, inflation figures, central bank announcements) trigger immediate exchange rate reactions
  • Unexpected or surprising developments lead to significant currency fluctuations
• Technical analysis, studying past price patterns and trends, is used to forecast future exchange rate movements based on market psychology and investor behavior

Economic fundamentals and currency values

Economic growth and inflation differentials

• Economic growth differentials between countries influence exchange rates
  • Countries with higher growth rates relative to trading partners tend to experience currency appreciation
  • Increased demand for goods and assets from faster-growing economies drives currency appreciation
• Inflation differentials play a crucial role in determining exchange rates
  • Countries with higher inflation rates relative to trading partners may face currency depreciation
  • Higher inflation erodes purchasing power, making the currency less attractive

Trade balances and fiscal policies

• Trade balances and current account positions affect exchange rates
  • Countries with trade surpluses (exports exceeding imports) often experience currency appreciation
  • Trade deficits can lead to currency depreciation as more domestic currency is sold to purchase foreign goods
• Fiscal policies, such as government budget deficits or surpluses, can impact exchange rates
  • Large budget deficits may raise concerns about a country's ability to service its debt, potentially leading to currency depreciation
• Commodity prices influence currency values of major commodity exporters
  • Rising commodity prices can lead to currency appreciation for commodity-exporting nations (Canada, Australia)
  • Falling commodity prices may result in depreciation for those countries

Market expectations and exchange rates

Expectations and sentiment

• Market participants form expectations about future economic conditions, policy changes, and geopolitical events
  • Expectations drive short-term exchange rate movements as investors adjust positions accordingly
• Sentiment refers to the overall market mood and perception of a currency
  • Positive sentiment leads to increased demand and appreciation
  • Negative sentiment results in selling pressure and depreciation

News events and data releases

• News events and data releases shape market expectations and trigger immediate exchange rate reactions
  • GDP reports, inflation figures, and central bank announcements are closely watched
  • Unexpected or surprising developments lead to significant currency fluctuations
• Market participants react quickly to new information, adjusting their positions based on the perceived impact on currency values

Speculative activities and technical analysis

• Speculative activities, such as carry trades or momentum trading, amplify exchange rate movements based on market expectations
  • Speculators buy currencies with higher interest rates or those expected to appreciate
  • Speculative activities can create self-fulfilling prophecies and exacerbate currency trends
• Technical analysis involves studying past price patterns and trends to forecast future exchange rate movements
  • Chart patterns, support and resistance levels, and momentum indicators are used to identify potential entry and exit points
  • Technical analysis assumes that market psychology and investor behavior can be captured in price charts

Interest rate differentials vs purchasing power parity

Interest rate differentials and capital flows

• Interest rate differentials between countries are a key driver of exchange rate movements
  • Higher interest rates in one country relative to another attract capital inflows
  • Increased demand for the high-yield currency leads to appreciation
• Uncovered interest rate parity suggests that the interest rate differential should equal the expected change in the exchange rate over the same period
• Covered interest rate parity involves using forward contracts to hedge against exchange rate risk
  • Forward premium or discount offsets the interest rate differential

Purchasing power parity (PPP) theory

• PPP theory states that exchange rates should adjust to equalize the purchasing power of different currencies
  • Exchange rate between two countries should be equal to the ratio of their price levels
• Absolute PPP compares price levels directly, while relative PPP focuses on the change in price levels over time
  • Deviations from PPP occur due to trade barriers, transaction costs, and non-traded goods
• The law of one price underlies PPP, stating that identical goods should have the same price across countries when expressed in a common currency
  • Violations of the law of one price create opportunities for arbitrage (buying in one market and selling in another)

Long-run equilibrium and real exchange rates

• In the long run, exchange rates tend to move towards their PPP levels
  • Price differentials between countries are expected to converge over time
  • Short-term deviations from PPP are common due to market inefficiencies and other factors
• Real exchange rates adjust nominal exchange rates for inflation differentials
  • Real exchange rates assess the competitiveness of a country's exports and the purchasing power of its currency over time
• Balassa-Samuelson effect explains why prices of non-traded goods tend to be higher in more developed countries
  • Productivity differences between traded and non-traded sectors lead to real exchange rate appreciation in developed economies