How Currency Exchange Rates Are Determined
Currency rates of exchange appear to be moving in response to so many factors that it makes it almost impossible to ascertain where the rate of exchange is likely to be headed. Rather than paying attention to the multitude of variables, it is more sensible to focus on the essential variable.
As far as currency rate of exchange determination is concerned, this variable is the relative changes in the purchasing power of various monies. In short, it is the relative purchasing power of various monies that sets the underlying rate of exchange.
A price of a basket of goods is the amount of money paid for the basket. We can also say that the amount of money paid for a basket of goods is the purchasing power of money with respect to the basket of goods.
If in the US the price of a basket of goods is $1 and in Europe an identical basket of goods is sold for 2 euros then the rate of exchange between the US$ and the euro must be two euros per one dollar.
An important factor in setting the purchasing power of money is the supply of money. If over time the rate of growth in the US money supply exceeds the rate of growth of European money supply, all other things being equal, this will put pressure on the US$.
Since a price of a good is the amount of money per good, this now means that the prices of goods in dollar terms will increase faster than prices in euro terms, all other things being equal.
As a result an identical basket of goods is priced now; let us say at $2, as against 2.5 euro. This would imply that the exchange rate between the US$ and the euro will be now 1.25 euros per one dollar.
Note the fact that changes in a local money supply affect its general purchasing power with a time lag means that changes in relative money supply affect the currency rate of exchange also with a time lag.
When money is injected into the economy it starts with a particular market before it goes to other markets – this is the reason for the lag.
When it enters a particular market it pushes the price of a good in this market higher – more money is spent on given goods than before.
This in turn means that past and present information about money supply can be employed in ascertaining likely future moves in the currency rate of exchange.
Another important factor in driving the purchasing power of money and the currency rate of exchange is the demand for money. For instance, with an increase in the production of goods the demand for money will follow suit.
The demand for the services of the medium of exchange will increase since more goods must now be exchanged.
As a result, for a given supply of money, the purchasing power of money will increase. Less money will be chasing more goods now.
Various factors, such as the interest rate differential, can cause a deviation of the currency rate of exchange from the level dictated by relative purchasing power. Such deviations, however, will set corrective forces in motion.
Let us say that the Fed raises its policy interest rate while the European central bank keeps its policy rate unchanged.
We have seen that if the price of a basket of goods in the US is one dollar and in Europe two euros, then according to the purchasing power framework the currency rate of exchange should be one dollar for two euros.
As a result of a widening in the interest rate differential between the US and the Euro-zone an increase in the demand for dollars pushes the exchange rate in the market toward one dollar for three euros.
This means that the dollar is now overvalued as depicted by the relative purchasing power of the dollar versus the euro.
In this situation it will pay to sell the basket of goods for dollars then exchange dollars for euros and then buy the basket of goods with euros – thus making a clear arbitrage gain.
For example, individuals will sell a basket of goods for one dollar, exchange the one dollar for three euros, and then exchange three euros for 1.5 basket, gaining 0.5 of a basket of goods.
The fact that the holder of dollars will increase his/her demand for euros in order to profit from the arbitrage will make euros more expensive in terms of dollars – pushing the exchange rate in the direction of one dollar for two euros.
An arbitrage will always be set in motion if the rate of exchange deviates, for whatever reasons, from the underlying rate of exchange.