Why Foreign Exchange Rates Change

While almost every economic event has at least some indirect influence on the relative value of different currencies, there are generally six major factors that cause the value of currencies to rise or fall relative to one another. Let's take a look at each one:

Purchasing power parity. This theory – first presented in the sixteenth century – is possibly the most important factor that causes the relative values of two currencies to change with regard to each other over time. In an oversimplified form, "PPP" suggests that the same goods should cost the same amount of money in different countries, allowing for the then-current rate of exchange. If this were not true, it would create the possibility of a virtually riskless arbitrage (which is the simultaneous or near-simultaneous purchase and resale of the same securities, commodities, or foreign exchange in different markets in order to profit from unequal pricing). The arbitrage would cause the value of the currency of the country in which the goods were cheaper to increase relative to the currency of the country in which the goods were more expensive.

To illustrate the concept, let's assume that – at a time when the exchange rate of Japanese yen to U.S. dollars is 100:1 – an ounce of silver can be bought or sold for 550 yen in Japan and for $5 in the United States. Under these circumstances an investor could conceivably buy silver in the United States for $5 per ounce and immediately turn around and sell it in Japan for 550 yen per ounce. The investor could then straight away buy dollars with the yen received from that sale at the then-current exchange rate of 100:1 for a net of $5.50 – or a $0.50-per-ounce profit. Provided the transactions occurred nearly simultaneously, the tactic would be almost completely of risk. The investor could then repeat these dealings over and over again.

As a result, several things would happen. Because the investor buys the silver in the United States, the price of silver in the U.S. would begin to rise. Further, because the silver is sold in Japan, the price of silver there would decline start to fall. And due to the exchange of yen for dollars, the value of the yen would decline relative to the dollar. The prices of silver in Japan and the U.S., as well as the yen-to-dollar exchange rate, would continue to change until the transactions no longer generate a risk-free profit. Keep in mind, however, that this example is an oversimplification, because transaction charges, import duties, shipping costs and the like aren't factored into the calculation. Although the price differential would strengthen the yen against the dollar, the price differential of other products might result in the weakening of the yen. Whether PPP works to actually raise or lower the value of the yen against the dollar, therefore, ultimately depends upon the net price differential of all the goods and services that are traded between the United States and Japan, always allowing for the then-current rate of exchange.

Relative interest rates. Another factor that affects exchange rates is the size of the differential between the real interest rates available to investors in the respective countries. The real interest rate is simply the nominal interest rate available to an investor in a high quality short-term investment subtracted by the country's inflation rate.

Using our same two example countries again, let's this time assume that the U.S. has a hypothetical nominal interest rate of 8% and an inflation rate of 3%. Its real interest rate would therefore be calculated at 5% (8% - 3%). Assume Japan's nominal interest rate is 3% while its inflation rate is at 2%; this would give Japan a real interest rate of 1%. Because the real investment return available in the United States is five times larger than the investment return available in Japan, some percentage of Japanese investors can be expected to want to invest in the U.S. In order to do that, however, they'll first have to sell their yen to buy dollars. This exchanging of yen for dollars will cause the dollar to rise against the yen. Additionally, U.S. investors will have less incentive to invest in Japan and, consequently, will reduce their buying of yen with dollars.

Trade imbalances. The size of any trade deficit between two countries will also affect those countries' currency exchange rates. This is because they result in an imbalance of currency reserves among the trading partners. Once more using Japan and the U.S., consider the following example:

Throughout the 1980s and 90s, Japan consistently ran fairly substantial trade surpluses with the United States. Consequently, Japanese companies accumulated a large amount of dollars, while U.S. companies amassed significantly fewer yen. Eventually, however, the Japanese companies must convert the dollars that they accumulated into yen and the United States companies must convert their yen into dollars. Given the mismatch in the amount of currencies to be exchanged between the two countries, the law of supply and demand would tend to distort the exchange rate. The American companies found themselves in a strong position to demand a greater number of dollars in exchange for their limited amount of yen. Thus, the U.S. trade deficit with Japan caused the yen to strengthen against the dollar.

Political stability. During the gold standard of the past, currencies were backed by, and interchangeable with, precious metals. Anyone who held a country's currency could present the currency to the country's central bank (or any major bank in the country) and receive a fixed amount of gold or silver. Over the last few decades, however, the tremendous increase in the size of the economy created a need for money that far outdistanced the ability of the mining industry to produce gold. Therefore, the United States, like all other countries, had little choice other than to discontinue the gold standard. This meant that holders of paper dollars could no longer exchange them for gold.

Today, instead of precious metals, "confidence" backs the world's currencies. The only reason that anyone is willing to accept paper money in exchange for their goods or services is because they're confident that they'll be able, in turn, to pass the paper money on to someone else in exchange for the things that they want or need. Most countries require their citizens to accept their paper money as payment; this is known as legal tender. As long as the citizenry's confidence remains intact, the system works. However, if a country's government becomes unstable due to political gridlock, votes of no confidence, revolution or civil war, confidence can quickly be lost. People become less willing to accept paper currency in exchange for their goods and services, primarily because they're unsure whether they'll be able to pass the paper along to the next person.

Government intervention. The relative value of a country's currency is of great importance to its government. The value of a country's currency affects the wealth of its citizens, the competitiveness of domestically produced goods, the relative cost of the country's labor, and the country's ability to compete. As a result, governments often try to influence the relative value of their country's currencies in a number of different ways, including altering their monetary and fiscal policies, and by directly intervening in the currency markets.

The term monetary policy refers to a country's decisions regarding how much money to print. In the United States, this decision falls primarily on the Federal Reserve, commonly called the Fed. The law of supply and demand applies no less to money; therefore, if a country prints more money, the value of its currency declines – a process known as monetary inflation. If a country prints less money, or more specifically, if the money supply grows at a rate that's lower than the growth rate of the economy, the result is deflation. As the value of a country's currency declines, its people become less wealthy but its businesses become more competitive globally. More competitive businesses translate into more jobs. The Fed's policy makers constantly try to balance the preservation of wealth of the country's citizens with the competitive needs of domestic companies.

Fiscal policy refers to a country's decision regarding whether to run a budget deficit or a surplus. In the U.S., Congress determines the nation's fiscal policy. A budget deficit will cause the value of the dollar to decline because such deficits often lead to monetary inflation. A budget surplus will generally cause the dollar's value to strengthen.

Because short-term variations can have a negative impact on business and global trade, most countries will attempt to reduce any short-term fluctuations in the value of their currencies by directly intervening in the currency market. If the country's currency is being sold, they will buy it; if the currency is being bought and becomes too strong, they'll sell it.

Speculators. Perhaps the most powerful factor that can influence exchange rates over short time frames is the role that speculators play. Speculators typically have tremendous amounts of capital that they can use to either buy or sell any currency. Consequently, their actions can cause the value of such currency to fluctuate, sometimes quite significantly.