Exchange rates play a critical role in global finance — but how are exchange rates determined?
The primary function of exchange rates is to set the worth of a given world currency compared to another. The results can impact several areas of international commerce, including import and export prices and global travel costs. Exchange rate determination also guides how influential market forces decide financial plans and policies.
Various factors shape how exchange rates are determined. They include currency supply and demand, interest rate movements, and several other economic indicators. Additionally, there are two forms of exchange rates: floating and fixed.
How are exchange rates determined? This post takes a deeper dive into the mechanics and conditions that drive how they are set and what impacts they have on the world economy.
Understanding Exchange Rate Determination
Exchange rate determination is the act of setting the value of one country’s currency in relation to another. The action takes place on the forex market, in which international currencies are traded between investors.
Currencies fall under two main types of exchange rate systems. The floating exchange rate is set by the forex market as an evaluation of the supply and demand of a given currency. It’s a signal of a currency’s strength and interest rate changes compared to another.
A fixed exchange rate is constant and does not change. It is set by a country’s central bank or other government forces, binding the exchange rate to another country’s currency — most commonly the United States — or current gold prices. The objective of a fixed rate is to keep the currency’s value within a relatively stable, predetermined range.
Floating and fixed exchange rates have their benefits and drawbacks. How effective they are is driven by a nation’s prevailing economic conditions and stated policies.
The Role of Currency Supply and Demand
The principle of supply and demand may be the strongest influence on currency exchange rates. When demand for a given currency is higher, so is its value. When supply for a currency outpaces demand, its value decreases. Supply and demand are fundamental aspects of international business.
A few considerations go into establishing the supply and demand of a certain currency. One is the trade balance between countries. If a country has a trade surplus — meaning it exports more goods and services than it imports — then its currency is most likely in high demand.
Foreign investment also affects exchange rates. When a foreign investor purchases assets and commodities from another country, they have to convert their home currency into that of the other nation. This shores up the currency’s value in the forex market.
When more money goes out and overwhelms incoming capital, the currency may be worth less. This condition often occurs in periods of financial tumult or interest rate fluctuations.
All of these factors come into play in the forex market, whose traders also influence how much a certain currency is worth.
How Interest Rates Come Into Play
Interest rates dictate how much stakeholders earn on their returns on investment. They are set by the nation’s central bank system, such as the U.S. Federal Reserve or European Central Bank. Higher interest rates are more attractive to foreign capitalists, as they indicate that investors will see more in capital profits. This plays into the supply and demand principle: Investors want the currency, so its value is higher.
On the other hand, lower interest rates make a country’s currency weaker. Its financial assets and bonds are less appealing to traders who understandably want higher returns.
Central bank systems manipulate interest rates to manage capital growth, control inflation, and maintain their currencies’ value. If a country’s economy is undergoing a tough stretch, its leaders might cut rates to encourage more investment and lending. However, this can backfire if imports to the country become overpriced and its exports become cheaper.
We see the impact of interest rates when the Federal Reserve raises them. The U.S. dollar generally gets stronger as a result, with foreign investors increasing their capital commitments to U.S. commodities.
Economic Indicators and Exchange Rates
Foreign investment is the most significant measure of a country’s economic prospects. A country’s internal economic indicators paint a picture of its economic outlook as it relates to foreign capital. What economic indicators are at work, and how are exchange rates determined in light of them?
GDP Growth
When a country expands economically, it invites foreign capital as investors seek to capitalize on the growth. This generates gross domestic product (GDP) gains and widens demand for the country’s currency, increasing its value.
Inflation
Stable, low inflation rates generally improve a nation’s currency value. It’s a signal of economic consistency that permits banks to keep interest rates reasonable. High inflation, however, can cut into currency value by restricting returns on investment.
Employment
When a country’s job growth is strong and unemployment rates are low, it signifies economic strength. This in turn boosts consumer confidence and spending, raising the currency’s value. Conversely, stagnant job markets, cuts, and high unemployment rates decrease the currency’s worth.
Floating vs. Fixed Exchange Rates
Exchange rate systems are differentiated by whether they’re floating or fixed. Both systems have their relative advantages and disadvantages.
Floating Exchange Rates
Floating exchange rates are set by players and situations in the forex marketplace. They’re more volatile and susceptible to market forces discussed in this post: supply and demand, interest rates, and economic data. Floating rates can also be impacted by market disruptions, changes in investor sentiment, and world events.
Examples of floating exchange rates are the United States, the European Union, and Japan. They’re market-driven and tied to the policies of each area’s central banking system.
Fixed Exchange Rates
Countries with fixed exchange rates peg their currency’s value to a relatively stable currency — such as the American dollar — or a valuable commodity, most commonly gold. Central banks and government forces play a much bigger part in maintaining the value. The Chinese yuan is an example of a fixed currency.
Heavily monitored fixed exchange rates are perceived as more stable and predictable than floating rates. However, they result in more financial restraints and inflexibility. Governments must work harder to preserve value, keeping foreign reserves in hand to maintain the “peg.” This limits the country’s monetary autonomy and can drain its financial resources.
How Are Exchange Rates Determined? Two Historical Examples
How do exchange rate determinations affect the economy of a country? Here are two fairly recent examples of how they’ve played out.
When the United Kingdom — a floating exchange rate country — left the European Union after Brexit in 2016, it created immediate trade barriers for businesses headquartered in the U.K. This severely impacted inflation, the labor pool, imports, and exports. By 2022, the British pound’s value compared to the U.S. dollar had sunk by nearly 19%.
Hong Kong has fixed its currency rates to the U.S. dollar since 1983. The Monetary Authority has maintained the value range of the Hong Kong dollar to 7.75 to 7.85 of its U.S. counterpart. This has required the special administrative region of China to hold considerable foreign reserves — far more than its monetary base — to keep value intact.
Exchange Rates: Dictating the Global Marketplace
How are exchange rates determined? Through a series of proven economic structures, national policy, foreign investment, and reliable indicators. With a working understanding of the forces at work, investors can make more guided decisions on where to apply their capital investments for better returns.
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