How Currency Rates Are Determined

Date Wednesday, September 17th, 2008

The study of how currency rates or exchange rates are determined is studied in economics. It is studied in the stand of economics called macroeconomics. There are two different types of exchange rates a country can enforce and they are fixed or floated.

Fixed exchange rates are where the Reserve Bank or related body sells and buys foreign currency, using their home currency (If it was the US Reserve Bank, they will buy and sell currency using USD). By buying and selling foreign currency the reserve bank can determine the exchange rates. But if the Reserve Bank runs out of foreign exchange they stop buying, they will have to sell foreign exchange to build up their foreign exchange reserves so they can start selling currency again.

But most countries use a floated exchange rate; a floated exchange rate is where the supply and demand determines the exchange rate. Unlike fixed exchange rates, floated exchange rates have no government intervention.

The causes of exchange rate change are:

* An increase or decrease in imports
* An increase or decrease in exports
* An increase or decrease in inflation

The causes will shift the supply or demand function to the left and right, this will decrease or increase the exchange rate. The exchange rate determines the purchasing power of countries money, however in the long run one country’s money will be the same as another’s.

With the supply and demand of foreign exchange determining the currency rates, what does this mean in simple terms? It means the market ultimately decides the currency rates and its worth, if there is huge demand for a countries currency, that countries currency rate will rise, however if the demand for a countries currency falls, that countries currency rate will fail.

A country’s inflation also plays a part in determining the country’s currency rate. If a country has a high inflation rate then their currency is worth less, thus they have a low currency rate, however if a country has a low inflation rate then their currency is worth more, thus they have a high currency rate.

A country’s interest rate is also important. Interest rates determine if investors are likely to invest in that country, such as buying Government bonds, shares etc. If the interest rates are high, the investor will look elsewhere, but if the interest rates are low the investor may invest in that country. Other factors that could influence the investor in choosing to invest in a country include taxes and Government intervention.

I hope that helps you understand how currency rates are determined.

by Tim Hawthorne

Leave a Reply