Determination of Exchange Rates

In simple terms, it is the interaction of supply and demand factors for two currencies in the market that determines the rate at which they trade. But what factors influence the many thousands of decisions made each day to buy or sell a currency? How do changes in supply and demand conditions explain the path of an exchange rate over the course of a day, a month, or a year?

This complex issue has been extensively studied in economic literature and widely discussed among investors, officials, academicians, traders, and others. Still, there are no definitive  answers. Views on exchange rate determination differ and have changed over time. No single approach provides a satisfactory explanation of exchange rate movements, particularly short- and medium-term movements, since the advent of widespread floating in the early 1970s.

Three aspects of exchange rate determination are discussed below. First, there is a brief description of some of the broad approaches to exchange rate determination. Second, there are some comments on the problems of exchange rate forecasting in practice. Third, central bank intervention and its effects on exchange rates are discussed.

Some approaches to exchange rate determination:

1. The Purchasing Power Parity Approach

Purchasing Power Parity (PPP) theory holds that in the long run, exchange rates will adjust to equalize the relative purchasing power of currencies. This concept follows from the law of one price, which holds that in competitive markets, identical goods will sell for identical prices when valued in the same currency.

The law of one price relates to an individual product. A generalization of that law is the absolute version of PPP, the proposition that exchange rates will equate nations’ overall price levels. More commonly used than absolute PPP is the concept of relative PPP, which focuses on changes in prices and exchange rates, rather than on absolute price levels. Relative PPP holds that there will be a change in exchange rates proportional to the change in the ratio of the two nations’ price levels, assuming no changes in structural relationships. Thus, if the U.S. price level rose 10 percent and the Japanese price level rose 5 percent, the U.S. dollar would depreciate 5 percent, offsetting the higher U.S. inflation and leaving the relative purchasing power of the two currencies unchanged.

PPP is based in part on some unrealistic assumptions: that goods are identical; that all goods are tradable; that there are no transportation costs, information gaps, taxes, tariffs, or restrictions of trade; and —implicitly and importantly—that exchange rates are influenced only by relative inflation rates.

But contrary to the implicit PPP assumption, exchange rates also can change for reasons other than differences in inflation rates. Real exchange rates can and do change significantly over time, because of such things as major shifts in productivity growth, advances in technology, shifts in factor supplies, changes in market structure, commodity shocks, shortages, and booms.

In addition, the relative version of PPP suffers from measurement problems:What is a good starting point, or base period? Which is the appropriate price index? How should we account for new products, or changes in tastes and technology?

PPP is intuitively plausible and a matter of common sense, and it undoubtedly has some validity—significantly different rates of inflation should certainly affect exchange rates. PPP is useful in assessing long-term exchange rate trends and can provide valuable information about long-run equilibrium. But it has not met with much success in predicting exchange rate movements over short- and medium-term horizons for widely traded currencies. In the short term, PPP seems to apply best to situations where a country is experiencing very high, or even hyperinflation, in which large and continuous price rises overwhelm other factors.

2. The Balance of Payments and the Internal- External Balance Approach

PPP concentrates on one part of the balance of payments—tradable goods and services— and postulates that exchange rate changes are determined by international differences in prices, or changes in prices, of tradable items.

Other approaches have focused on the balance of payments on current account, or on the balance of payments on current account plus long-term capital, as a guide in the determination of the  appropriate exchange rate.

But in today’s world, it is generally agreed that it is essential to look at the entire balance of payments—both current and capital account transactions—in assessing foreign exchange flows and their role in the determination of exchange rates.

John Williamson and others have developed the concept of the “fundamental equilibrium exchange rate,” or FEER, envisaged as the equilibrium exchange rate that would reconcile a nation’s internal and external balance. In that system, each country would commit itself to a macroeconomic strategy designed to lead, in the medium term, to “internal balance”—defined as unemployment at the natural rate and minimal inflation—and to “external balance”—defined as achieving the targeted current account balance. Each country would be committed to holding its exchange rate within a band or target zone around the FEER, or the level needed to reconcile internal and external balance during the intervening adjustment period.

The concept of FEER, as an equilibrium exchange rate to reconcile internal and external balance, is a useful one. But there are practical problems in calculating FEERs.There is no unique answer to what constitutes the FEER; depending on the particular assumptions, models, and econometric methods used, different analysts could come to quite different results. The authors recognize this difficulty, and acknowledge that some allowance should be made by way of a target band around the FEER.Williamson has suggested that FEER calculations could not realistically justify exchange rate bands narrower than plus or minus 10 percent.

The IMF, while generally agreeing that it is not possible to identify precise “equilibrium”values for exchange rates and that point estimates of notional equilibrium rates should generally be avoided, does use a macroeconomic balance methodology to underpin its internal IMF multilateral surveillance.

3. The Monetary Approach

The monetary approach to exchange rate determination is based on the proposition that exchange rates are established through the process of balancing the total supply of, and the total demand for, the national money in each nation. The premise is that the supply of money can be controlled by the nation’s monetary authorities, and that the demand for money has a stable and predictable linkage to a few key variables, including an inverse relationship to the interest rate—that is, the higher the interest rate, the smaller the demand for money. In its simplest form, the monetary approach assumes that: prices and wages are completely flexible in both the short and long run, so that PPP holds continuously, that capital is fully mobile across national borders, and that domestic and foreign assets are perfect substitutes. Starting from equilibrium in the money and foreign exchange markets, if the U.S. money supply increased, say, 20 percent, while the Japanese money supply remained stable, the U.S. price level, in time, would rise 20 percent and the dollar would depreciate 20 percent in terms of the yen.

In this simplified version, the monetary approach combines the PPP theory with the quantity theory of money—increases or decreases in the money supply lead to proportionate increases or decreases in the price level over time, without any permanent effects on output or interest rates. More sophisticated versions relax some of the restrictive assumptions—for example, price flexibility and PPP may be assumed not to hold in the short run—but maintain the focus on the role of national monetary policies.

Empirical tests of the monetary approach— simple or sophisticated—have failed to provide an adequate explanation of exchange rate movements during the floating rate period. The approach offers only a partial view of the forces influencing exchange rates—it assumes away the role of nonmonetary assets such as bonds, and it takes no explicit account of supply and demand conditions in goods and services markets. Despite its limitations, the monetary approach offers very useful insights. It highlights the importance of monetary policy in influencing exchange rates, and correctly warns that excessive monetary expansion leads to currency depreciation.

The monetary approach also provides a basis for explaining exchange rate overshooting—a situation often observed in exchange markets in which a policy move can lead to an initial exchange rate move that exceeds the eventual change implied by the new long-term situation. In the context of monetary approach models that incorporate short-term stickiness in prices, exchange rate overshooting can occur because prices of financial assets—interest and exchange rates—respond more quickly to policy moves than does the price level of goods and services.

Thus, for example, a money supply increase (or decrease) in the United States can lead to a greater temporary dollar depreciation (appreciation) as domestic interest rates decline (rise) temporarily before the adjustment of the price level to the new long-run equilibrium is completed and interest rates return to their original levels.

4. The Portfolio Balance Approach

The portfolio balance approach takes a shorter-term view of exchange rates and broadens the focus from the demand and supply conditions for money to take account of the demand and supply conditions for other financial assets as well. Unlike the monetary approach, the portfolio balance approach assumes that domestic and foreign bonds are not perfect substitutes. According to the portfolio balance theory in its simplest form, firms and individuals balance their portfolios among domestic money, domestic bonds, and foreign currency bonds, and they modify their portfolios as conditions change. It is the process of equilibrating the total demand for, and supply of, financial assets in each country that determines the exchange rate.

Each individual and firm chooses a portfolio to suit its needs, based on a variety of  considerations—the holder’s wealth and tastes, the level of domestic and foreign interest rates, expectations of future inflation, interest rates, and so on. Any significant change in the underlying factors will cause the holder to adjust his portfolio and seek a new equilibrium.

These actions to balance portfolios will influence exchange rates. Accordingly, a nation with a sudden increase in money supply would immediately purchase both domestic and foreign bonds, resulting in a decline in both countries’ interest rates, and, to the extent of the shift to foreign bonds, a depreciation in the nation’s home currency. Over time, the depreciation in the home currency would lead to growth in the nation’s exports and a decline in its imports, and thus, to an improved trade balance and reversal of part of the original depreciation.

Nevertheless, the portfolio balance approach offers a useful framework for studying exchange rate determination. With its focus on a broad menu of assets, this approach provides richer insights than the monetary approach into the forces influencing exchange rates. It also enables foreign exchange rates to be seen like asset prices in other markets, such as the stock market or bond market, where rates are influenced, not only by current conditions, but to a great extent by market expectations of future events. As with other financial assets, exchange rates change continuously as the market receives new information about current conditions and information that affects   expectations of the future. The random character of these asset price movements does not rule out rational pricing. Indeed, it is persuasively argued that this is the result to be expected in a well functioning financial market. But in such an environment, exchange rate changes can be large and very difficult to predict, as market participants try to judge the expected real rates of return on their domestic assets in comparison with alternatives in other currencies.

How Good Are the Various Approaches?

The approaches noted above are some of the most general and most familiar ones, but there are many others, focusing on differentials in real interest rates, on fiscal policies, and on other elements.

The research on this topic has been of great value in enhancing our understanding of long-run exchange rate trends and the issues involved in estimating “equilibrium” rates. It has helped us understand various aspects of exchange rate behavior and particular exchange rate episodes.

Yet none of the available empirical models has proved adequate for making reliable predictions of the course of exchange rates over a period of time. Research thus far has not been able to find stable and significant relationships between exchange rates and any economic fundamentals capable of consistently predicting or explaining short-term rate movements.

Bookmark the permalink.