Exchange Rate Determination
Understanding what causes exchange rates to change is essential for analysing international competitiveness, the balance of payments, and macroeconomic policy. This lesson examines the factors that influence the demand for and supply of currencies in the foreign exchange market.
The Foreign Exchange Market
The foreign exchange (forex) market is a global, decentralised market where currencies are traded. It is the world's largest financial market, with daily turnover exceeding $7.5 trillion (Bank for International Settlements, 2022). The market operates 24 hours a day across major financial centres: London, New York, Tokyo, Singapore, and Hong Kong.
The exchange rate is determined by the interaction of demand for and supply of a currency.
Demand for a Currency
The demand for pounds sterling arises from:
- Exports of goods and services — foreign buyers need pounds to pay for UK exports.
- Foreign direct investment (FDI) into the UK — foreign firms investing in UK factories, offices, or companies need pounds.
- Portfolio investment — foreign investors buying UK government bonds (gilts), shares, or other financial assets need pounds.
- Speculation — if traders expect the pound to appreciate, they buy pounds now to sell later at a higher price.
- Tourism — foreign tourists visiting the UK need pounds.
- Remittances — workers abroad sending money to the UK.
An increase in demand for pounds shifts the demand curve to the right, causing the pound to appreciate.
Supply of a Currency
The supply of pounds sterling arises from:
- Imports of goods and services — UK buyers sell pounds to obtain foreign currency for imports.
- UK FDI abroad — UK firms investing overseas sell pounds to buy foreign currencies.
- UK portfolio investment abroad — UK investors buying foreign assets sell pounds.
- Speculation — if traders expect the pound to depreciate, they sell pounds.
- UK tourists travelling abroad — they sell pounds to buy foreign currency.
- Remittances from the UK — workers in the UK sending money to other countries.
An increase in the supply of pounds shifts the supply curve to the right, causing the pound to depreciate.
Key Factors Affecting Exchange Rates
1. Interest Rates
Changes in relative interest rates are one of the most important short-run determinants of exchange rates.
- If the Bank of England raises interest rates relative to other countries, UK assets offer higher returns.
- This attracts hot money — short-term capital flows seeking the highest return.
- Demand for pounds increases, and the pound appreciates.
- Conversely, a cut in UK interest rates (relative to other countries) causes capital outflows and depreciation.
Key Definition: Hot money refers to short-term, highly mobile capital flows that move rapidly between countries in response to differences in interest rates or expected exchange rate movements.
Example: When the US Federal Reserve raised interest rates aggressively in 2022–2023, capital flowed towards the US, causing the dollar to strengthen significantly against most currencies, including sterling.
2. Inflation Rates
Relative inflation rates affect exchange rates through their impact on international competitiveness.
- If UK inflation is higher than in its trading partners, UK exports become relatively more expensive and imports relatively cheaper.
- Demand for UK exports falls (reducing demand for pounds) and demand for imports rises (increasing supply of pounds).
- The pound depreciates.
- This relationship is formalised in Purchasing Power Parity (PPP) theory (Gustav Cassel, 1918), which predicts that exchange rates will adjust to equalise the price of identical goods in different countries.
Key Definition: Purchasing Power Parity (PPP) states that, in the long run, exchange rates should adjust so that a basket of goods costs the same in each country when expressed in a common currency.
Evaluation of PPP:
- PPP holds reasonably well in the very long run but is a poor predictor of short-run exchange rate movements.
- Transport costs, tariffs, non-traded goods, and differences in product quality mean that prices are rarely fully equalised.
- The Big Mac Index (The Economist) provides a lighthearted illustration: if a Big Mac costs £3.50 in London and 5.00inNewYork,PPPwouldsuggestanexchangerateof£1=1.43.
3. Speculation
Speculators trade currencies based on their expectations of future exchange rate movements. Speculation can be stabilising or destabilising: