Economics of Foreign Exchange Rates

The foreign exchange rate is the price of one currency in terms of another. Because the
foreign exchange rate compares the currencies of 2 countries, the rate depends on the value of
each currency and, thus, on the economies of both countries. There are 3 primary economic
factors that affect the foreign exchange rate:

the relative purchasing power of each currency;

the investment opportunities and risks of each country, and

the desirability of the goods and services of each country.

Although other factors can be enumerated, such as the international balance of payments,
they can all be subsumed under these 3 primary economic determiners of the foreign
exchange rate.

Purchasing Power Parity and Inflation

Goods and services have an intrinsic value that is commensurate with how well they satisfy
the needs and wants of the people. Because goods and services are provided so that the
providers can earn a profit, the quantity provided is limited by demand in the marketplace.
However, the quantity of money that is provided by the government has no such restrictions.
Through monetary policy, developed economies generally regulate the quantity of money to
achieve specific monetary objectives, which may not be related to the needs of the economy.
Sometimes governments will print money, or increase the money supply, to solve fiscal
problems.
If the economy grows in size, the money supply must grow with it so that prices remain
stable; otherwise, prices will decline because the quantity of goods and services will increase
faster than the money supply, resulting in deflation. When the money supply increases faster
than the economy, then inflation results. Hence, because goods and services have an intrinsic
value and because their quantity is limited by their profitability to the suppliers, the nominal
price of the goods and services is primarily determined by the quantity of money in the
economy.
Hence, if one currency can buy more goods and services than an equal amount of another,
then that currency will be more valuable; thus, there will be greater demand for it. This is
because a basket of goods and services will have the same value no matter where it is located,
so if that basket has a different nominal price in one country then in another, then the value of
the 2 currencies must be different.
Since governments can change the amount of their currency, or the quantity of money, at will
and at little cost, nominal prices are more dependent on the quantity of money than on the

good or service itself. Governments have often resorted to printing money, or increasing the
money supply, to solve fiscal problems. As the supply of the new money circulates within the
economy, demand temporarily increases, but because the economy is no larger, prices of all
goods and services increase proportionally to the money supply. Hence, the currency loses
value with respect to the goods and services.
Gold is a prime example of something that should have the same value anywhere, since gold
is an element that does not vary in quality. Even the demand for gold is fairly constant among
countries, since its main use is as a store of value. Because gold is a relatively rare element
that governments cannot simply create, it has the same value worldwide, and can be used as a
universal currency to buy the same basket of goods and services anywhere in the world. (To
simplify this discussion, we are ignoring some other factors that may account for real
differences in value in different countries, such as comparative advantages.)
For instance, if an ounce of gold costs $1250 or 1000, then euros must be more valuable
than United States dollars since it takes fewer euros to buy an ounce of gold. In fact, the price
of a dollar in euros must be the same as the dollar price of an ounce of gold divided by the
euro price of an ounce of gold.
Dollars

Price of Gold in Dollars

=

Euro

Price of Gold in Euros

This is the foreign exchange rate between dollars and euros, which, in this case, equals 1.25.
In other words, one euro can buy $1.25, and one dollar can buy 0.8. Hence:
1.25 / 1 = 1250 / 1000 = 1.25 or 1 / 1.25 = 0.80
Purchasing power parity means that if a basket of goods and services does not have the
same nominal price, then the foreign exchange value of each currency must be such that the
good or service will have the same value; otherwise arbitrage will eliminate any differences
in real value. Exporters and importers would transport the goods from the low cost country to
the high cost country until prices become more equalized.
Thus, Big Macs, iPads, and iPods will generally have the same value the world over most
of the differences in their currency price will generally be due to the differences in the value
of the currencies (ignoring minor logistical costs and cultural differences in demand for
certain products or services).

Investment Opportunities
Generally, a country that has better investment opportunities will attract international capital,
which will cause its domestic currency to increase in value relative to other currencies, since
the foreigners will have to exchange their currency for the investment country's currency to

make their investments, increasing the demand for the investment currency, and, thus, raising
its price, which is the foreign exchange rate.
Emerging markets, for instance, have attracted a considerable amount of international capital
because their underdeveloped markets have a greater potential for growth. Hence, money
invested in their stock markets will tend to grow more rapidly than in developed countries,
where the economies are much more mature. Indeed, sometimes a country retaliates against
any increasing appreciation of its currency by instituting capital controls, as Brazil did by
instituting a 6% tax on foreign purchases of Brazilian bonds.
Another measure of the investment opportunity differences between 2 countries is the
prevailing interest rates, which are heavily influenced by the monetary policy of the central
banks of each country.
For instance, consider the Japanese yen and the Australian dollar, otherwise known as the
Aussie. The Bank of Japan has kept its key interest rate close to zero, while the Reserve Bank
of Australia, which is Australia's central bank, has its key interest rate at 4.75% as of April 5,
2011. Hence, if the Japanese want to earn a decent return on their savings, many will
exchange their yens for Aussies and save their money in banks in Australia. Indeed, even
foreigners will borrow from Japanese banks to earn interest on deposits in Australian banks,
which is known as the carry trade.
This is why the currency of a country will increase or decrease in value with respect to other
currencies when the central bank increases or decreases its key interest rate, which is why
forex traders carefully monitor the news and press releases concerning central banks.
While higher returns attract capital, increased investment risks will cause investors to flee or
to stay away. Since inflation is a major investment risk, investors will avoid countries that are
printing money to solve fiscal problems, such as Zimbabwe or Venezuela. Political turmoil
will have a similar effect.
Sometimes investors react negatively to events that create uncertainty as to their impact on
the financial markets. For instance, Japan had a major earthquake in March, 2011, that caused
investors to unwind their carry trade, since it was difficult to predict how it would affect the
strength of the yen. If the yen appreciated, it would reduce the returns of the carry trade.
Indeed, the yen did temporarily appreciate, presumably on speculation that insurers and
investors would sell foreign assets for yen to help pay for Japan's worst earthquake. However,
the central banks of the G-7 countries intervened in the foreign exchange market by actively
selling yen to reduce its rise against other currencies because of the turmoil.

Relative Desirability of a Country's Goods and Services

The other economic factor that determines the foreign exchange rate is the desirability of the
country's goods and services compared to the other goods and services offered in the world

marketplace. If a country provides superior products or superior services or at a lower cost,

then foreigners will buy more from that country, thereby increasing the value of its currency.
For instance, the demand for United States dollars by Europeans would depend on how much
they want the goods and services of the United States, how much they want to travel in the
United States, and by how much they want to invest in the United States. It would also
depend on the relative supply of Euros and United States dollars.

Government Intervention
Although economic factors generally determine the foreign exchange rate, governments will
often intervene to achieve specific objectives. For instance, because Japan depends on
exports, the Bank of Japan keeps interest rates lower than most countries so that its exports
are price competitive.
China is another country that intervenes to keep its currency cheap by pegging the yuan to the
dollar so that Chinese exporters can maintain a significant price advantage over its
competitors. China can maintain the peg by purchasing United States Treasuries with its
United States dollars. China, in effect, maintains the peg by helping to finance the debt of the
United States.