what determines the value of an exchange rate

The global market for foreign exchange currencies is massive! - Hundreds of billions of £s and $s are traded in the dealing rooms each day. The market is open 24 hours a day for people, companies and governments needing foreign exchange to finance their transactions. Money now moves round the international financial system at tremendous speed (aided by the spread of computer technology and the gradual abolition of exchange controls between countries). Speculative activity in the market is a major determinant of a currency's value.

Short and long-term movements in the exchange rate, like any price, are caused by changes in market demand and supply conditions

Demand for Sterling

The demand for sterling (pounds) in the FOREX markets comes from four main sources:

UK goods and services are exported overseas - creating an inflow of currency into to the UK which needs to be turned into sterling
foreign investment flows into the UK economy
market speculators decide they want to purchase pounds in the expectation of making a profit
official buying of the currency by the central bank

An outward shift in the demand for sterling will cause an appreciation in the currency

Supply of Sterling

Sterling is sold on foreign exchange markets when

goods and services are imported (domestic consumers and firms sell sterling to finance their purchase of imports or when they go overseas on holiday)
speculators sell pounds for another currency
investment capital flows out of the UK seeking a better rate of return
central banks go into the market and sell pounds to buy other foreign currencies

When the demand for sterling is high relative to supply, sterling goes up in value (an appreciation). The reverse is true when the market supply of pounds exceeds the demand. (A depreciation). Consider the diagram below which shows the effect of an outward shift in market supply of sterling against the Euro. As a result we see a depreciation in the currency's value.

Fundamental factors that drive an exchange rate

INTEREST RATES

Interest rates have a large effect in a world where financial capital can move freely between countries.

When a country's interest rates are high relative to elsewhere this attracts inflows of money into a country seeking to take advantage of the high interest rates. This "interest differential" boosts the demand for the currency and can cause its value to rise.

ECONOMIC GROWTH

Countries experiencing a deep recession often find that their exchange rate is weakening. Traders in the currency markets may take the slow growth to be a sign of general economic weakness and "mark down" the value of the currency as a result.

On the other hand, economies with strong "export-led" growth may see their currency's rise in value. Japan is a good example of this in recent years. The Euro was weak during the first six months of its existence in part because the financial markets were worried about the slow growth of the European economy and the persistently high level of unemployment.

INFLATION

In the long run, those countries with higher than average inflation see their exchange rate fall. When inflation is high, a country becomes less competitive in international markets causing a fall in exports (a demand for a currency) and a rise in imports (a supply of currency overseas). A fall in the exchange rate may be needed to restore a country's competitiveness in overseas markets.

THE BALANCE OF PAYMENTS

Selling exports represents a demand for the domestic currency from foreign importers. When US consumers but British Whisky they supply dollars and this is eventually translated into a demand for pounds.

Similarly when UK consumers buy imports, they supply their own currency and this is eventually translated into a demand for foreign currencies. If a country is running a substantial trade surplus there is a large demand for the currency and its value should appreciate. By contrast a massive trade deficit usually causes the currency to lose value.

MARKET SPECULATORS

Special factors (such as political events, changing commodity prices etc.) can have an effect on a currency. In addition the power of market speculators has grown. When speculators decide that a currency is going to fall in value, they sell that currency and buy ones they anticipate will rise in value.

It is difficult for government's to offset the power of speculators because their reserves of foreign currencies are very small compared to daily turnover in the market. We saw in 1997 and 1998 speculative attacks on currencies in Asia and seven years ago, the pound was forced out of the European exchange rate mechanism because of speculative selling of the pound.

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