How are Currency Exchange Rates Determined?

Key Highlights

• The foreign exchange rate is determined by floating and pegged (fixed) rates.
• The floating rate is the one that is determined by the demand and supply.
• The fixed foreign exchange rate is determined by the central government of the country.

How Foreign Exchange Rates are Determined

The foreign exchange rate is determined in two main ways: a floating rate or a fixed rate. A floating rate is determined on the global currency markets by supply and demand. As a result, the value of the currency will increase if the demand for it is high.

The price of a currency will fall if demand is low. Many technical and fundamental factors determine what people perceive as a fair exchange rate and how their supply and demand are affected.

Between 1968 and 1973, most of the world's major economies allowed their currencies to float. As a result, most exchange rates are not fixed but are determined by ongoing trading activity on currency markets around the world.

Factors that Influence Exchange Rates

A foreign exchange rate is determined based on the following factors:

• Floating Rates

The market supply and demand determine floating rates. A currency's value in relation to another currency is determined by how much demand there is compared to supply. For instance, if Europeans want more U.S. dollars, the supply-demand relationship will raise the price of the U.S. dollar.

It's easy to change the exchange rate between two countries because of geopolitical and economic announcements. Some of the most common ones are interest rate changes, unemployment rates, inflation reports, gross domestic product numbers, manufacturing data, and commodities.

• Fixed Rates

The government sets fixed or pegged rates through its central bank. Currency rates are set against major world currencies (like the U.S. dollar, euro, or yen). As a means of maintaining its exchange rate, the government buys and sells its currency against the pegged currency.

Speculation, rumors, disasters, and everyday supply and demand cause short-term movements in a floating exchange rate currency. The currency will fall if supply exceeds demand, and it will rise if demand exceeds supply.

A central bank can intervene in a floating rate environment if extreme short-term movements arise. Thus, even though most major global currencies are considered floating, governments and central banks may intervene if a nation's currency becomes too high or too low.

If the currency is too high or too low, it can negatively impact trade and the nation's ability to pay debts. In order to bring their currency's price to a more favorable level, the government or central bank will implement measures.

• Macro Factors

Exchange rates are affected by macro factors as well. Under the "Law of One Price," the price of a good in one country should be the same as the price in another. It is referred to as purchasing price parity (PPP).

Price fluctuations can lead to a change in interest rates in a country or even a change in currency exchange rates. However, reality doesn't always follow economic theory, and several mitigating factors make the law of one price ineffective in practice. Nevertheless, interest rates and relative prices will influence exchange rates.

Another macro factor is the country's geopolitical risk and its government's stability. A country with an unstable government will see its currency fall in value relative to more developed, stable nations.

• Forex and Commodities

National currencies and commodity prices are usually correlated more strongly when a country's economy relies on a primary industry. It is not possible to predict what commodities a currency will be correlated with and to what extent this correlation will be; however, some currencies illustrate this relationship well.

For instance, the Canadian dollar is positively correlated with oil prices. The Canadian dollar appreciates as the price of oil goes up. It's because Canada exports oil, and when oil prices are high, it gets more revenue from its oil exports, so its currency gets a boost.

Similarly, the Australian dollar has a positive correlation with gold. Australian dollars move with gold prices because it's one of the world's biggest gold producers. The Australian dollar will also appreciate against other major currencies when gold prices rise significantly.

• Maintaining Rates

Some countries may use a fixed exchange rate and be maintained artificially by the government. This rate will not fluctuate intraday and may be reset on particular dates, known as revaluation dates. Governments in developing countries often do this to stabilize their currencies.

To keep the fixed exchange rate stable, the government should hold large reserves of the currency to which its currency is pegged. This will control changes in demand and supply.

Conclusion

The foreign exchange rate is determined by fixed rates and floating rates. Floating refers to rates that move freely with market demand and supply, while fixed are pegged to currency. The rates of currency change as per supply and demand. Factors that affect these rates are the political climate of the country, public debts, inflation, GDP, central government, commodities, etc. The central government intervenes to keep its currency strong and attempts to keep the demand for its currency high in foreign exchange markets.