According to popular thinking, a key factor in the foreign currency exchange rate determination is the state of the balance of payments. Following this logic, an increase in imports gives rise to an increase in the demand for foreign currency. To obtain the foreign currency importers sell the domestic currency for it. As a result, this causes a strengthening in the exchange rate of the foreign currency against the domestic currency i.e. more domestic currency per unit of a foreign currency.
Conversely, if there is an increase in exports, all other things being equal, then once exporters exchange their foreign currency earnings for domestic currency this sets in motion a strengthening in the domestic currency exchange rate against the foreign currency. (Less domestic currency per unit of a foreign currency).
In this way of thinking, exporters determine the supply of foreign currency whilst importers determine the demand for foreign currency. Hence, the interaction between supply and demand establishes a foreign currency exchange rate.
Following this logic, it makes sense to conclude that the state of the balance of payments, which is the result of the interplay between exports and imports, is a key in determining the foreign currency exchange rate.
Key factors determining demand and supply of foreign currency
Is it valid to suggest that exporters set the supply of foreign currency whilst the demand for it is set by importers?
For instance, the demand for the Yen emanates not only from American importers of Japanese goods and services but also from the Japanese themselves.
Every bit of economic activity that takes place in Japan gives rise to demand for Japanese money – the Yen. A Japanese producer of shoes exercises his demand for money by selling his product (shoes) for Yen, which in turn he could employ some time in the future, in order to be able to buy other goods and services.
Likewise, the producers of other goods and services exercising their demand for money by exchanging their produced goods and services for money, which in due course is going to be exchanged for other goods and services.
What is the source of the supply of foreign currency such as the Yen and the Euro? In the modern monetary system, the source is the central bank monetary policy and the fractional reserve banking. The quantity of the Yen and the Euros is set by the relevant central banks and fractional reserve banking and has nothing to do with the activity of exporters.
Moreover, we suggest that, with all other things being equal, the respective monetary policies of central banks determine the respective purchasing power of money. This in turn determines the exchange rates. Here is how.
The relative purchasing power of money and the exchange rate
A price of a basket of goods is the amount of money paid for the basket. We can also say that the amount of money paid for the basket of goods is the purchasing power of money with respect to the basket of goods.
If in the US the price of a basket of goods is $1 and in Europe an identical basket of goods is sold for 2 Euros then the rate of exchange between the US$ and the euro must be two Euros per one dollar.
An important factor in setting the purchasing power of money is the supply of money. If over time the growth rate in the US money supply increases against the growth rate of European money supply, all other things being equal, this is going to put pressure on the US$.
Now, a price of a good is the amount of money per good, this means that the prices of goods in dollar terms are going to increase faster than prices in Euro terms, all other things being equal.
Another important factor in driving the purchasing power of money and the exchange rate is the demand for money. For instance, with an increase in the production of goods the demand for money is likely to follow suit.
The demand for the services of the medium of exchange is likely to increase since more goods are now going to be exchanged. As a result, for a given supply of money, the purchasing power of money is going to increase. Less money will be chasing more goods now.
Deviation of the exchange rate from the relative purchasing power sets in motion arbitrage
Any deviation of the exchange rate from the rate set by the relative purchasing power of money is likely to set in motion arbitrage, which will undo the deviation. The deviation could emerge because of the market response to the trade account data or because of a change in the interest rate differential. We suggest that these deviations are likely to set corrective forces in motion.
Let us say that the Fed raises its policy interest rate while the European central bank keeps its policy rate unchanged. We have seen that if the price of a basket of goods in the US is one dollar and in Europe two euros, then according to the purchasing power framework the currency rate of exchange should be one dollar for two euros.
Because of a widening in the interest rate differential between the US and the Euro-zone an increase in the demand for dollars pushes the exchange rate in the market toward one dollar for three euros. (The holders of Euro’s are now demanding more dollars that are going to be placed in deposits earning higher interest rates).
Notwithstanding, the dollar is now overvalued as depicted by the relative purchasing power of the dollar versus the euro (it should be two euro to one dollar and not three euro to one dollar). In this situation, it will pay to sell the basket of goods for dollars then exchange dollars for euros and then buy the basket of goods with euros – thus making a clear arbitrage gain.
For example, individuals could sell a basket of goods for one dollar, exchange the one dollar for three euros, and then exchange three euros for 1.5 basket, gaining an extra 0.5 of a basket of goods.
The fact that the holder of dollars increased his/her demand for euros in order to profit from the arbitrage is going to make euros more expensive in terms of dollars i.e. more dollars per euro – pushing the exchange rate in the direction of one dollar for two euros.
We suggest that an arbitrage is always set in motion once the rate of exchange deviates, for whatever reasons, from the underlying rate of exchange.
Summary and conclusion
Contrary to a popular belief, the state of the balance of payments has nothing to do with the determination of currencies exchange rates. The key factor behind the rate of exchange determination is the relative purchasing power of various monies.