The exchange rate is the rate at which one country’s currency trades or exchanges against another country’s currency. Simply put, if there are two countries US and India, how many Indian Rupees equate to 1 USD? You can also write it as the ratio of one currency over another currency.
Many factors influence how the exchange rates are set. In this post, you will learn about those, but first, let’s understand where the currency exchange takes place.
The currency exchange happens in the foreign exchange market, also called the forex market. It is the global marketplace that sets the exchange rate for currencies around the world. It is a decentralized or over-the-counter market for the trading of currencies at their current market price.
Foreign exchange markets include large international banks, central banks, multinational companies, investment banks, forex dealers, hedge funds, etc. All of these buy, sell, exchange, and make guesses on the relative exchange rates of any two currency combinations.
Why do we care about exchange rate fluctuations?
For any international currency transaction, you need to know the exchange rate. So, if the current exchange rate is 1 USD=80 Indian Rupees, this means when you go to India, you would get approx. Rs 80 for 1 USD. Similarly, if an Indian comes to the US, they would have to pay approx. Rs 8000 to get $100. In real life, foreign exchange dealers make a small profit on any foreign exchange transaction.
USD appreciated against major currencies of the World
Recently, in the news, you must have heard that the US Dollar has appreciated against major currencies of the world. I found this chart from IMF’s Oct 4, 2022 blog post and it shows the US dollar vs major currencies. You can see how the USD appreciated against the British Pound sterling, Japanese Yen, Indian Rupee, Euro, and many others since the start of 2022.
The IMF post stated that economic fundamentals are a major factor in the appreciation of the dollar. Rising US interest rates and its more favorable terms-of-trade compared to other countries in Eurozone, UK, Japan and China have caused the US dollar to emerge stronger.
Don’t worry if this isn’t clear to you yet, I will explain this mechanism in just a bit.
What factors influence a price of a currency against another currency?
The answer to this question lies in the fundamental economic concept of excess demand. The price of a currency relative to another currency will go up if there is more demand for it.
A country’s exchange rate can either Appreciate, which is an increase in the value of the currency, or the exchange rate
Or
Depreciate/devalue, which is a decrease in the value of a country’s currency or the exchange rate.
Below I have a chart from google finance showing a continued appreciation of USD or the depreciation of Indian Rupees. Twenty years ago, the exchange rate for 1 USD was around 45 Rupees. Since then, the demand for USD has been rising and the price of USD relative to the Indian Rupee has been rising. As of Oct 15, 2022, it is 82 Rupees to 1 USD.
In the graph below, you can see how the intersection of demand and supply determines the price or exchange rate. We will take call point A as the year 2014 when the exchange rate for 1 USD was 65 Indian Rupees, where demand and supply met.
With a continued increase in demand for USD, the demand curve shifted up to the right. With the same supply, the new intersection happens at point B, at this point the price of 1 USD is 80 Rupees in Oct 2022. Thus, if the demand for a currency is high relative to another currency, its exchange rate will go up. The opposite will happen when the demand for a currency is low relative to another currency.
What causes a change in the demand for a currency?
Many factors can influence the currency’s demand and the exchange rate. Let’s understand the most important ones below. Since we are looking at the appreciation of the USD against major currencies, I will use USD as an example to explain it.
- Relative Interest rates
When interest rates are higher in a country there are more money inflows in the US. This happens because international investors would invest there to get better returns. As investment happens in the USD, there’s more demand for USD. This causes the USD value or the exchange rate to appreciate.
- Relative inflation
A low and stable inflation rate also plays a key role. Many developed countries such as the US, and the UK have had inflation of around 2% in the past. Although this has changed recently after the pandemic and Ukraine war, it is still lower than in many other countries.
A low Inflation rate in the U.S. relative to another country, such as India, can cause the US currency to appreciate. Let me explain why this happens. Low inflation in the US will mean US imports become cheaper to India and India will demand more US-made goods. I just want to point out that when India imports from the US, it pays for those in USD. So, increased demand for US imports will lead to increased demand for USD. This will cause its relative value or exchange rate to rise against the Indian rupee. For more than a year US economy has been witnessing high inflation. The reason USD is going strong is because other countries are dealing with even higher inflation.
- Current account surplus
A current account is the balance of trade between a country and other countries it does international trade with. It includes all the payments between countries for physical goods, services, interest, and dividends. A deficit in the current account shows a country’s imports are more than its exports. To cover this deficit, that country will usually borrow capital from other foreign countries. This causes its currency to depreciate.
- Relative Strength of the economy
Also, the relative strength of the US in comparison to other developed countries plays a role too. If the world is worried about other developed countries’ performances such as the UK, EU, and Russia, the U.S. dollar price will rise in the international market.
- Speculation
Also, expectation and speculation play a role in determining a currency exchange rate. If more people believe that the value of the U.S. dollar will rise relative to other currencies in the future, they will demand more of the US dollar to sell it later for a profit. This is going to further increase the demand for the U.S. dollar causing an increase in its value.
- Relative Competitiveness
If businesses in the US become more competitive relative to the UK, this will also cause an increase in demand for US-made goods causing an appreciation or increase in the value of the U.S. dollar compared to the pound sterling.
Conclusion
In the long run, how strong a country’s economy is and how competitive it is relative to its other countries will determine its exchange rate. A technological innovation that leads to higher productivity will strengthen that country in the international market and will lead to an appreciation in its value.
What has caused exchange rate fluctuations can be hard to pinpoint, as most of the time several factors play the role.
Clearly, an appreciation in the US dollar has made travel to the UK and other countries much more affordable for the US people. To see who all benefit from the appreciation or depreciation of a currency, stay tuned for my next post.
Credit: Images from Freepik
