Currency exchange rate is essentially the value of one currency in terms of another currency. The need for rates of exchange stems from the fact that one currency is hardly accepted in another currency. For example if you are in the Philippines and would like to purchase an item say a pair of Jeans, you will have to exchange your dollars into the local currency first before you can buy from the local store. On the macro level, countries importing goods from another country will also need to exchange their own currencies for the local currency of the country they are doing business with. The rates of exchange play a vital role on how businesses are conducted between countries.
The rates of exchange between any pair of currencies are constantly changing by the day, by the hour, by the minute. How and why they constantly fluctuate may seem to be a mystery to many but it is actually simply always the end result of supply and demand equations. Just as the price of cotton will go up when demand for it exceeds available demand, so it is too with a pair of currencies. When the demand for US goods from Europeans perks up, the demand for US dollars naturally goes up, too and the rates of exchange will rise favorably for the US currency. Conversely, if the demand for US goods ebbs, then the demand for the US Dollar also wanes and the rates of exchange goes down unfavorably against the US currency.
In essence, the strength of a currency reflects the demand for the products of the particular country and is a measure of its economic strength or weakness. However, simple as the law of supply and demand may seem, the factors that influence the balance between the two are more complicated and requires a bit of effort to understand and appreciate. From an economist point of view, the various factors that affect both the supply side and the demand side are constantly interplaying to strike a balance or equilibrium.
An example of such interplay is when a higher currency exchange rate makes imports less expensive creating a spike in demand to a point that prices rise as supply starts to dwindle and the local currency starts to rise. As the local currency starts to appreciate and the prices rise, the demand is stymied to a point that the demand dwindles to the extent that imports slow down. Ultimately, the prices are pushed down again to revive the demand for the products. It is a vicious cycle that almost always tries to strike equilibrium.
What determines Exchange Rates
Exchange rates are always a comparison between the currencies of a two countries and there are a number of factors that determine these rates all of which are related to the trade conducted between these two countries.
- Differences in Inflation Rates: As observed, countries with constantly lower inflation rates often experience a rise in the purchasing power of their currencies compared to their countries while countries with consistently higher inflation rates experience a depreciation of their currencies compared to others.
- Interest Rate Differentials: Higher interest rates offer investors and lenders higher returns for their money. Capital flight naturally follows high interest rates while lower interest rates shun away capital.
- Deficits in Current Account: Current Account, which is the balance of trade between one country and its global trading partners, affects the rate of its currency. A deficit means the country is spending more (imports) than what it is able to earn (export). In other words, they need more foreign currencies and resort to borrowing which ultimately lowers the rates of exchange of its own currency.
- Political Stability and Economic Performance: Countries which are politically stable and have shown strong economic performance attract foreign investors, whereas countries in political turmoil scare investors away and take their capital with them to place in more politically stable countries.
Exchange rates are determined by a number of complex factors that often befuddle even the most experienced economists. The ordinary forex investor may find them too cumbersome and even overwhelming to learn. It is however vital that they must have a working knowledge and a bit of understanding on how currency exchange rates are determined so they can have a better chance of achieving better returns for their investments.