What are the determinants of Foreign Exchange?

In earlier part 1, we have a brief introduction of what are foreign exchange transactions, foreign exchange rate and market.

So what determines a country’s foreign exchange rate? Append below are some three(3) major factors that determines or have an important impact on future exchange rate movements in a country’s currency:


Salient points:

The basics about  price inflation’s theories which can impact the country’s future exchange rate:

·         The Law of One Price: dictates that in competitive markets free of transportation costs and barriers to trade like tariffs, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency

·         Purchasing Power Parity(PPP):  if the abovesaid Law of One Price is true for  all goods & services, the Purchasing Power Parity(PPP) exchange rate could be found from any individual set of prices. By comparing the prices of an identical product in different currencies, it would be possible to determine the “ real “ or PPP exchange rate that would exist if markets were efficient. This theory advocates that the exchange rate will change if relative prices change.

·         Money Supply and Price Inflation: Inflation occurs when the quantity of money supply increases faster than output increases. Generally, the increase in a country’s money supply changes the relative demand and supply conditions in the foreign exchange market.


·         Generally where inflation is expected to be high, the interest rate will also be high, because investors want compensation for the decline in the value of their money-this is known as Fisher Effect where it states that a country’s “nominal” interest rate (i) is the sum of the required “real” rate of interest(r) and the expected rate of inflation over the period for which the funds are to be lent(I)



·         On the short term/run, exchange rate movement is sometimes greatly influence  by market/investor’s psychology.These psychological factors sometimes greatly impact the determining expectations of market traders to future exchange rates.- We call this the “bandwagon” effect.

·         Market psychological factors are greatly influence by political factors, microeconomic events and others

·         Example: George Soros, a currency speculator wreak havoc on the Thai Baht in 1997. His actions followed by others is a typical example of the aforesaid bandwagon effect. Incidentally, because of this, the Thai baht loss more than 50% of its value against the USD




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