Name the factors behind exchange rate determination and explain how they operate.
The idea
Exchange rates in a floating system move with the supply of and demand for currencies, and several factors drive them. Relative inflation matters. Higher domestic inflation makes exports less competitive and imports more attractive, so the currency tends to depreciate. Relative interest rates matter through capital flows. Higher real rates attract foreign capital and tend to appreciate the currency, but a rise in nominal rates that only matches higher expected inflation does not. Relative income growth matters through import demand. Faster domestic growth raises imports and the demand for foreign currency, which tends to weaken the domestic currency. Government factors include trade barriers, which lower import demand, and central bank intervention, where selling the domestic currency to buy foreign currency weakens it. Expectations and risk perceptions shift capital flows. The exam trap is using nominal rather than real rates, or ignoring the risk premium behind a yield rise.
A practice question
Other things equal, how does a rise in a country's inflation rate relative to its trading partners' inflation rates usually affect the value of its currency under a floating exchange rate?
- It tends to appreciate, because higher prices raise the amount of foreign currency each unit can buyWhy not: Higher relative prices reduce, not raise, the currency's purchasing power and demand.
- It has no lasting effect, because exchange rates are driven only by interest ratesWhy not: Inflation differentials are a core determinant, through trade flows and purchasing power parity.
- It tends to depreciate, because exports become less competitive and imports rise, cutting demand for the currency - correct
- It tends to appreciate, because the central bank must raise the exchange rate to offset inflationWhy not: Under a floating rate the central bank does not set the exchange rate to offset inflation.
Higher relative inflation makes domestic goods more expensive, lowering export demand and raising imports. Demand for the currency falls relative to supply, so it tends to depreciate.
A harder one
A country imposes new import tariffs, and no other country retaliates. In the standard analysis, ceteris paribus, what happens to the country's currency?
- It tends to appreciate, because less demand for imports means less demand for foreign currency - correct
- It tends to depreciate, because tariffs raise domestic prices and so reduce purchasing powerWhy not: The price effect is secondary; the direct effect is the fall in demand for foreign currency, which supports the domestic currency.
- It is unaffected, since tariffs change prices but not the demand for currenciesWhy not: Tariffs reduce import volumes, so currency demand changes.
- It tends to depreciate, because exporters will lose competitiveness at onceWhy not: Tariffs on imports do not directly affect export competitiveness, and retaliation is ruled out.
Tariffs cut import volumes, so importers need less foreign currency. With unchanged export demand the supply of the domestic currency falls and it tends to appreciate, absent retaliation and offsetting effects.
The hardest tier
A country's central bank raises its policy rate by 2 percentage points, but expected inflation rises by 3 percentage points over the same period. Which is the most likely effect on the currency, other things equal?
- It tends to appreciate, because the higher nominal rate attracts capital inflowsWhy not: Looks at the nominal rate only; investors respond to the real return, which fell here.
- It tends to appreciate by about 2%, matching the increase in the policy rateWhy not: Nothing ties the percentage change in the currency to the rise in the policy rate, and the real rate fell.
- It tends to depreciate, because the real interest rate has fallen by about 1 percentage point and so capital inflows weaken - correct
- It is unaffected, because nominal and real rates cancel outWhy not: Real rates changed by about minus 1 point, so the incentive for capital flows has changed.
Real rate is roughly nominal less expected inflation. A 2-point rise in the nominal rate with a 3-point rise in expected inflation leaves the real rate about 1 point lower, reducing the attraction of domestic assets.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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