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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:
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.
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
Euro
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.
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.