How are currency exchange rates set?

How are currency exchange rates set?

In the foreign exchange market, each currency has a value relative to other currencies. One US Dollar costs 108 yen, 72 Indian Rupees, 0.82 euros, and so on.

But how is this value determined? Who decides that one dollar is worth 72 INR in the foreign exchange market?

This article dives deep into how currency exchange rates are set under different exchange rate systems and what are the factors causing exchange rates to rise or fall?

How is the exchange rate determined?

There are three types of exchange rate systems and each system has its unique way of determining its exchange rate.

1. Fixed Exchange Rate System: A fixed exchange rate is when the central bank of a country pegs its own currency to that of another currency (or a basket of currencies) and maintains this currency rate over a period of years.

The Qatari government, for example has fixed its exchange rate to US$1 = 3.64 Qatari Riyals in the foreign exchange market. The Qatar Central Bank makes sure that this exchange rate is maintained by controlling the demand and supply of foreign exchange. When demand for the Qatari Riyal increases in the foreign exchange market due to any given reason, the Central Bank will decrease supply for the Qatari Riyal in order to keep the currency at its defined rate.

2. Free Floating Exchange Rate System: In a free-floating exchange rate system, the exchange rate is set according to the demand and supply forces of the foreign exchange market, without any government intervention.

As demand for a currency increases, the exchange rate will appreciate as more people are interested in buying the currency. Once the exchange rate increases, the products in international market will be more expensive which will force buyers to move to cheaper alternatives and hence demand and supply will be normalized. The free floating exchange rate system is a self-correcting system and does not need supervision all the time, unlike the fixed exchange rate system.

3. Managed Exchange Rate System: A managed exchange rate system has the abovementioned advantages of both the exchange rate systems and eliminates their disadvantages. In a managed exchange rate system, the exchange rate is set by foreign exchange market forces but the government only intervenes into the foreign exchange market when the exchange rate runs the risk of getting out of control i.e. gets too high or too low.

What causes currency exchange rates to fluctuate?

Now that we know how an exchange rate is set in different systems, there are also some factors that will cause the exchange rate to appreciate (increase) or depreciate (decrease).

1. Inflation: When a country is experiencing domestic inflation, the exchange rate will depreciate. In fact, inflation is one of the most common factors influencing exchange rates.

Domestic inflation leads to expensive raw materials and hence local producers will struggle in the international market to compete. This can lead to lesser demand for exports leading to depreciation of the currency.

2. Current Account Position: The current account comprises of i) the trade balance of the country’s goods and services, ii) net income, iii) direct transfers and iv) asset income. A current account deficit denotes that the country has spent more money than it earns and a surplus means that the country has earned more than it spent.

A serious current account deficit can lead to exchange rate depreciation as the supply of a nation’s currency has increased in the foreign exchange market. As supply has increased, the exchange rate will automatically fall to meet the new level of demand.

Info Nugget: Lebanon has recently experienced currency depreciation (in 2019) due to a consistent current account deficit.

3. Interest Rates: The interest rate is directly proportional to the value of the currency. A high interest rate will attract foreign investment which will increase the demand for your currency leading to an appreciated exchange rate.

Tip: If you are looking to invest in another country, make sure to look at their interest rate history before arriving at your investment decision.

4. Political and Economic Stability: Political instability can also lead to exchange rate depreciation. Immediately after the Brexit referendum result was announced in Great Britain, the Pound Sterling experienced its highest fall in a single day in over 30 years. Political uncertainty can lead to a frenzy selling of the currency on the foreign exchange in order to avoid any major losses.

Economic stability can also affect the exchange rate. For example, USA attracts foreign investment because the US Dollar is the most popular currency for saving your money. This is because the US Dollar is a strong currency and its exchange rate has been stable for a long time. This economic stability gives confidence to investors when investing in your currency. Conversely, economic uncertainty might force current investors to pull out their money and invest in other secure currencies.