Causes of currency changes
Definition
Exchange rate: the price of one currency in terms of another; under a floating system it is set purely by the demand for and supply of that currency.
Hot money: short-term financial capital that moves rapidly between countries to chase the highest interest rate or an expected currency gain.
- A rise in demand for the currency, or a fall in its supply, bids its price up, so it appreciates.
- A fall in demand, or a rise in supply, pushes its price down, so it depreciates.
Key Idea
- A floating exchange rate is simply a price set by the demand for and supply of the currency.
- Anything that shifts either curve moves the rate, so trace every cause back to demand or supply.
The main causes
- Trade flows
- Rising foreign demand for exports raises demand for the currency, because buyers must obtain it to pay, so it appreciates.
- Rising domestic demand for imports raises the supply of the currency, because importers sell it for foreign money, so it depreciates.
- Investment and capital flows
- Inward foreign direct investment and portfolio inflows raise demand for the currency, causing appreciation.
- Outward investment abroad raises the supply of the currency as residents sell it, causing depreciation.
- Speculation
- If speculators expect the currency to rise they buy now, adding to demand and causing appreciation.
- If they expect a fall they sell now, adding to supply and causing depreciation, so expectations can be self-fulfilling.
- Relative interest rates
- A rise in domestic interest rates relative to abroad attracts hot money inflows, raising demand for the currency and causing appreciation.
- Lower relative interest rates trigger capital outflows, raising the supply of the currency and causing depreciation.
- Relative inflation rates
- Higher domestic inflation than trading partners makes exports less price-competitive, cutting demand for exports and for the currency, causing depreciation.
- It also makes imports relatively cheaper, raising import demand and the supply of the currency, which reinforces the depreciation.
Example
- Suppose the central bank raises its policy rate from 2% to 4% while trading partners hold theirs at 2%, drawing in hot money that shifts demand for the pound right and lifts it from $1.20 to $1.30.
- The pound appreciates by about 8.3%, so each £1 now buys more dollars, an appreciation driven by capital flows rather than trade.
Which cause dominates
- In the short run speculation and interest-rate shifts usually dominate, because daily capital flows dwarf trade flows.
- In the long run relative inflation and trade competitiveness matter more, in line with purchasing power parity.
- So it depends on the time horizon, and on how other currencies are moving at the same time.
Exam technique
- Always explain a movement as a shift in the demand for or supply of the currency.
- Name the specific cause, such as an interest-rate rise or higher relative inflation.
- Use appreciation and depreciation, not revaluation and devaluation, under a floating system.
- Evaluate by short run versus long run and the relative size of capital and trade flows.
Common Mistake
- Do not confuse appreciation with revaluation.
- Appreciation is a market rise under floating, while revaluation is a deliberate rise under a fixed system.
- Do not forget that higher relative interest rates usually strengthen a currency.
- They attract inflows of hot money seeking higher returns.
Self review
- What determines a floating exchange rate?
- Name four causes of a change in a floating exchange rate.
- How does a rise in relative interest rates usually affect the currency, and why?
- Why does higher relative inflation tend to cause a currency to depreciate?
- What is the difference between appreciation and revaluation?
