Traditional macroeconomic exchange-rate models are based on fundamental analyses. In these models, the basic force that drives currency’s rate comes from the balance between supply and demand of currency, for example if the demand for the U.S. dollar exceeds its supply at the current exchange-rate against the euro the price of US dollar in terms of the euro will rise. Conversely, if supply exceeds demand, the price will fall. Demand and supply factors that govern currency’s rate’s become much more complex than that because people don’t use currencies just to purchase foreign goods and services, but also for activities like cross-border investment and speculation. This opens up many other variables that must be considered when addressing exchange-rate movements, as underscored in the Federal Reserve Bank of New York’s commentary cited previously. One of the most important factors, for example, is how investors ride interest-rate differentials between countries.
We know that interest is the price paid to entice people with funds to save rather than spend, or to invest in long-term assets rather than hold cash. Therefore, interest rates reflect the interaction between the supply of savings and the demand for capital, or between the demand for money and its supply. A key determinant of these interest-rates is inflationary expectations. Global investors broadly desire a real return from their investments, and changes in forecasts over future inflation are consequently reflected in current exchange-rates. “Real return” here refers to the interest rate minus the inflation rate.
Here is an example of how this works: If Australia’s interest-rates are higher than Japan’s then Japanese investors will for example, want to buy Australian bonds to take advantage of the higher rates and corresponding returns. But to do so they must first sell Japanese yen and buy Australian dollar at the current exchange-rate between the two currencies. Next, Japanese investors are not likely to park their money in Australian bonds indefinitely and, at some point in the future, will want to bring their proceeds home and convert them back to yen. So they will also be interested in having an idea of what the currency rate between the yen and the Australian dollar will be in the future. The expected return for these investors will have to factor in both the interest rate and the expected movement in exchange rate between the two currencies. That is, the demand for yen will depend not only on, the current exchange rate, but also on anticipation of future currency rate movements against the Australian dollar. The Japanese investors’ exchange rate predictions will, in turn, be influenced by their estimate of what the inflation rates will be in each country. If inflation in Australia rises above the prevailing interest rates, the Japanese investors will then expect a weakening of the Australian dollar. If Japanese inflation is lower than the prevailing interest-rates then the Japanese yen will become more attractive.