What factors determine the exchange rates?

The exchange rate is the price of one currency expressed in units of another currency. For example, at the beginning of 2017, 1 U.S. dollar exchanged for about 21 Mexican Peso, 1 euro exchanged for 4.4 Polish Zloty, and one Brazilian Real exchanged for 0.41 Canadian Dollars. We say that a currency is appreciating/depreciating relative to another currency if it takes more/less units of the other currency to purchase it.

The exchange rate appreciates when the demand for the currency increases, i.e. when more people want to buy it and depreciates when the supply increases, i.e. when more people want to sell it. Look at it from the U.S. perspective. Foreigners want to buy dollars when they:

1. Invest in the U.S.
2. Buy goods and services from the U.S.

At the same time U.S. citizens sell dollars when then they:

1. Invest overseas.
2. Buy foreign goods and services.

Holding all else constant, if foreign investment in the U.S. increases, this will create more demand for dollars, and the dollar will appreciate. Similarly, when U.S. citizens increase their international travel, that creates additional supply of dollars and the dollar will depreciate.

Several examples

U.S. interest rates increase. That leads to greater foreign investment into the U.S., greater demand for dollars, and dollar appreciation.

New tariffs on U.S. exports to Europe. Now foreigners buy fewer U.S. goods, the demand for dollars declines, and the dollar depreciates.

The U.S. economy is growing rapidly. On one hand, that attracts foreign investment and causes dollar appreciation. On the other hand, U.S. imports increase since Americans can buy more international goods and services and cause dollar depreciation. We are not sure which effect would be stronger but usually a growing economy is associated with an appreciating currency.

Expected appreciation of the dollar. If for some reason investors believe that the dollar will appreciate in one year, they will want to buy it now. This creates additional demand for dollars and leads to appreciation now.

If you wonder what the effect of some macroeconomic variable on the exchange rate is, ask yourself how, holding everything else constant, that variable affects the demand or the supply of the currency. Based on that, you can determine if the change is likely to lead to appreciation or depreciation.

Forecasting currency values: short, medium, and long run

Of course, in reality there are multiple macroeconomic changes occurring at the same time. Interest rates may be changing in various countries, GDP growth rates differ, trade flows shift, etc. The combination of all these factors makes it virtually impossible to predict the exchange rate at short horizons (days, weeks). Too many fundamentals are moving in different directions at the same time. Therefore, economists say that the exchange rate follows a “random walk”, i.e. the best forecast of tomorrow’s exchange rate is today’s exchange rate. The likelihood of appreciation and depreciation are the same.

At medium-term time horizons (months, a few years) the effect of particular macroeconomic fundamentals on the exchange rate becomes more visible. For example, if the economy is growing rapidly its currency is likely to appreciate as the country attracts international capital that creates demand for the local money.

In contrast, in the long-run (many years, decades) macroeconomic fundamentals cease to have a role. Over such long periods of time, the economic growth rates, interest rates, as well as international trade and investment flows have stabilized at some “average” levels. Then, the only determinant of the exchange rate is the rate of money supply growth. Countries that print money more rapidly than the rest of the world will experience currency depreciation. In fact, the size of the depreciation would be equal to the increase of the money supply. Recall that the exchange rate is the price of a currency. If you create too much of it the price will come down.

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