How Exchange Rates Are Determined

Whether planning an overseas holiday, buying goods from another country, or trading in the global financial markets, exchange rates subtly affect your life more than you may realize. Without realizing it, exchange rates—the value of one currency against another—can influence the cost of your morning coffee (if it is imported), the price of your dream trip, or even the profit on a business deal.

But have you ever thought about what makes the exchange rate? These numbers are not just random numbers flashing across a screen. Instead, they are the result of interaction between multiple economic forces, political events, and market psychology. In this article, we will break down the main components that determine exchange rates, describe how they relate to each other, and assist you in gaining a clearer perspective on the fluctuating exchange rates.

Understanding the basics: What is an exchange rate?

An exchange rate will tell you how much of one currency you can buy for another currency. For example, if the EUR/USD exchange rate is 1.10, this means that one euro equals 1.10 US dollars. An exchange rate can represent floating currencies (which change regularly based on market forces) or fixed (or pegged) currencies, where a central bank keeps the exchange rate at a fixed level to another currency.

Most major currencies today represent floating currencies, meaning that their value fluctuates instantaneously based on supply and demand in the global marketplace.

Factor 1. Supply and Demand

Like just about everything else in economics, supply and demand are significant determinants of exchange rates. If more individuals want a specific currency, its value will typically increase; if fewer individuals want it, then its value will generally decrease.

Demand for a currency can increase when:

•  The goods and services of a country are in demand globally.

•  Foreign investors are purchasing the assets (stocks, bonds, and real estate) of a country.

•  Interest rates are attractive not only locally, but in comparison to other countries.

Similarly, if a country is importing far more than it is exporting, it may create more demand for the currency of a foreign country, which could weaken its currency.

Factor 2: Interest Rates

Central banks – such as the US Federal Reserve and the European Central Bank – have tremendous influence over exchange rates through their monetary policy decisions. When a country raises its interest rates, it creates more demand for foreign investment, as investors can receive better returns. This changes the demand for the currency and pushes the price of the currency higher.

The opposite is true when interest rates are cut; investors may move their cash elsewhere, and the demand for that currency will lessen.

Factor 3: Inflation

Inflation, or the rate at which prices are increasing, will also influence exchange rates. Countries with low inflation typically have a stronger currency, as the purchasing power remains stable over time. Too high an inflation rate reduces the value of a currency and makes it less attractive to investors.

For instance, if Country A has an inflation rate of 2%, while Country B has an inflation rate of 10%, investors will typically want to hold Country A's currency, and the demand for it will push the currency up relative to Country B's currency.

Factor 4: Economic Conditions

A strong, growing economy that produces stable growth will attract foreign investment that creates demand for the currency of that country. GDP, employment, and production will all affect the exchange rate.

In general terms, when the economic data is consistently above estimates, the currency will rise. When an economy is weak, investors usually sell the currency for something more secure or that offers a higher return on investment.

Factor 5: Political Stability

Major political events, such as elections or changes in government policy, can move the exchange rate exponentially and fast. Uncertainty is often disliked by investors, who prefer a higher level of certainty. Suppose a country has a government political structure that is orderly and stable and has a transparent legal framework. In that case, it is usually perceived as a safer place to invest that currency and ultimately creates more support for that currency, leading to an increase in currency value.

Political uncertainty or instability can create capital flight, which is the movement of money out of a country, creating an increase in the supply of the currency and usually causing that currency to lose value.

Factor 6: Market Sentiment and Speculation

There are situations where the exchange rate moves off traders' expectations, market sentiment, or even a rumor, rather than any economic data. Traders may speculate that a currency will strengthen and purchase it (dollar cost averaging) often beyond its value because of their anticipated movements, usually referred to as a self-fulfilling prophecy.

Speculation can create massive increases in value and huge drops in value, usually surrounding uncertainty or significant news events.

Fixed vs.Floating Exchange Rates

Most major developed economies utilize floating rates, but some countries fix (or "peg") their currency to another currency, often the US dollar. In such a case, the central bank takes actions to proactively intervene in the currency market, at times actively holding the currency at a fixed rate (e.g., Hong Kong's HKD to USD) - for trade and investment stability, while also limiting the central bank's ability to react to current economic opportunities in the market.

How Central Banks Intervene

Since most foreign currencies operate on a floating system, central banks, from time to time, intervene in some way to change the prevailing value of their currency. The central bank may decide to buy or sell its currency on the vast open market, raise or lower interest rates, and forward contracts are also sometimes used to send signals to traders willing to buy or sell.

These actions are generally because the central bank does not wish to see significant levels of volatility in their dollar value, or they are trying to shape their currency's value in light of their economic goals.

Real World Example: The USD/JPY

Consider the US dollar and Japanese yen. If the US Federal Reserve raises interest rates while the Bank of Japan continues to keep rates low, many investors may look to sell Japan's currency and purchase US dollars based on returns. Such a move would strengthen the US dollar over the Japanese yen.

On the other hand, if Japan's economy projects strong growth and US economic data weakens, it could also signify Japan's yen could gain value against the US dollar.

The Role of Global Events

Significant global events - wars, pandemics, natural disasters - can have immediate effects on foreign exchange rates. When an essential international event occurs, funds come into countries perceived to have a global 'store of value' while geopolitical upset is underway. These funds will usually flock towards the US dollar, Swiss franc, and Japanese yen as currencies are much safer when the world is experiencing an upheaval.

Amid such global uncertainty, this often signifies a rise in the US dollar as an international store of value.

Why It Matters

If you're traveling, understanding how the foreign exchange market works can help you determine the best time to purchase foreign currency. If you're a business importing and exporting products and services globally, managing the foreign exchange rate could mean the difference between profiting from an international deal or losing company dollars to the foreign exchange market. If you're a trader or investor, understanding a country or territory's foreign currency exchange rates can make a difference in making strategic, informed decisions.

Even for the local folks not directly tied to trading or dealing with currency, foreign exchange (FX) rates will ultimately affect everything from the cost of imported goods to inflation rates to the economy in its entirety.

In Closing

Exchange rates are generally the product of the interplay of numerous economic factors (supply and demand, interest rates, inflationary factors, economic performance, political economy (stability), market sentiment, and so forth. There is no accurate way to know what rate will be achieved at a future date. However, understanding the primary economic drivers of foreign exchange rates can inform your decisions when trading on the foreign exchange market, whether you're a Forex trader, an investor looking abroad, or simply purchasing stocks on vacation.

The next time you look at a currency board and see those numbers change, you'll know they represent more than numerical mathematics; they are also a real-time economic snapshot of the staff pulse of the world's economy.