Exchange Rate Determinants
Exchange rate determinants are factors that would cause a nation’s currency to depreciate or appreciate in value. They
are the principles that guide the understanding of exchange markets, and they help producers gauge or predict exchange
rate occurrences. Here are three key factors to keep in mind when considering determinants:
1.The first factor to remember is rather simple and is based on the law of demand: If the demand for a nation’s cur-
rency increases, that currency will appreciate in value. If the demand for a nation’s currency decreases, that cur-
rency will depreciate in value.
2.The second factor is based on the law of supply. The supply of a nation’s currency is inversely related to the value
of that nation’s currency. If a nation increases the amount of its currency, the currency depreciates. If a nation
decreases the quantity of its currency, then the currency appreciates.
3.The third factor to keep in mind is based on the connection currencies have to each other. If one country is bene-
fiting from an increasing or appreciating currency, then another country is experiencing a depreciating currency.
It is not possible for all currencies to be appreciating at the same time. Currencies become interdependent of one
another; therefore, as one rises in value, it is benefiting from the depreciation of another currency.The three factors above help illustrate the concept of a determinant. The following sections discuss specific determinants.
Changes in Interest Rates
If two countries are trading, they are likely to become accustomed to the exchange rates they are using. If interest rates
in the countries fluctuate, that may alter the exchange rate between the two countries. If the interest rates increase in
country A and stay the same in country B, country B will find country A a beneficial place to make a financial invest-
ment. As country B makes investments, it will have to convert its currency into country A’s currency. This increases the
quantity of country B’s currency, thereby depreciating it. Country A’s currency appreciates relative to country B.
Price Level Changes
If the purchasing power of one nation’s currency declines, the result could be a reevaluation of exchange rates with its
participating countries. Whenever the price level fluctuates considerably, countries that are trading with one another
must realign their exchange rates. The price level can determine the exchange rate between trading partners.
Income Changes
When a nation’s national income grows too quickly, it is likely to depreciate. When the economy is growing rapidly,
incomes are growing at a rapid rate as well. When national income rises, individuals increase their consumption of for-
eign and domestic goods. A country’s demand for international goods increases, and in turn this depreciates the dollar
because of its international availability.
Taste and Preference Changes
Changes in tastes and preferences of a good or service alter the demand of that good or service. When the demand is
altered, the demand for the country’s currency is also altered. If Japanese televisions become more attractive to U.S.
buyers, then exchange rates will favor the Japanese because of American consumers flooding the international market
with the U.S. dollar.
Before current exchange policies were developed, countries used a universally valued form of currency. Gold was used
to back currencies and regulate money supplies. Countries used gold as a universally valuable tool to trade and exchange.
Here are some facts regarding the international exchange of gold:
■ Countries used gold to back their currencies up until the 1930s.
■ Countries gauged their money supply with the amount of gold they possessed.
■ Countries imported and exported gold, thereby appreciating and depreciating their currencies.Part III: Microeconomics