Factors Influencing Foreign Exchange Market

Shortly after the Fed announced an increase in interest rates, the value of the U.S. dollar against the Euro went up. What are the factors influencing foreign exchange market? Was it because of the rise in the interest rate? How can a change in policies affect the foreign exchange rate? Can the U.S. government cause the U.S. dollar to appreciate or depreciate? Do you want to learn about these and much more? Then read on!

Factors Influencing Foreign Exchange Market Explanation

Today, many of the goods we buy are imports from other countries. While we buy these goods in our currency, the U.S. dollar, the producer of the goods requires payment in their currency--the Euro, British pound, Mexican peso, or any of the many other currencies that exist worldwide. At some point, the U.S. dollars we pay at the store for an imported good must be exchanged for the currency used by the producer. This is the purpose of the foreign exchange market.

The value of all currencies rises or falls based on supply and demand in the FOREX market. Factors affecting supply and demand change the equilibrium exchange rate in the foreign exchange market.

Demand Factors

Demand for a currency is directly tied to demand for the imported products purchased with that currency. For example, demand for the Japanese yen is directly tied with demand for Toyota automobiles, Nintendo video game consoles, and Sony electronics.

When Japan exports more of these goods to other countries, importers in these other countries have an increased demand for the Japanese yen. More exports mean a nation's currency is gaining in value due to increased demand. This gain in value is called appreciation. Conversely, less demand for a country's exports will lead to reduced demand for that country's currency. The reduction in value is called depreciation.

Investors also demand currencies to invest in the nations using those currencies. When a nation has relatively low inflation, stable interest rates, and political stability, it is seen as favorable for investment, and the demand for its currency will rise. That's why the role of the government in building favorable conditions for the foreign exchange market is crucial for attracting new investors and raising the value of their domestic currency.

Supply Factors

There is a limited supply of all currencies on the FOREX market, and the supply of currencies on the FOREX market changes. When we import goods from a foreign country, we must sell our domestic currency and buy the goods using the foreign currency. As more imports occur, the domestic currency is sold in the FOREX market, raising the currency's supply. Effectively, this "replaces" the exporter's currency on the FOREX market with the importer's currency. This means that the exporter's currency is decreasing in supply (causing its value to rise) while the importer's currency is increasing in supply (causing its value to decrease).

Another supply factor is monetary policy which directly impacts the currency flow in the market. When the central bank decides to increase the money supply, more currencies are in circulation, which causes a depreciation of the currency.

Examples of Factors Influencing Foreign Exchange Market

Let's consider an imaginary where the U.S. government would allocate a huge part of its budget to fund research and development for cancer. Let's assume that the U.S. government-backed start-ups invent the cure for cancer. As a result, all the other countries will have to buy the medicine from the U.S. But to buy the medicine, they have to pay in U.S. dollars. Graphically, one can look at the change in currency values from exporting medicine from either the demand perspective. Foreigners have increased demand for the U.S. dollar to buy U.S. exports. This is how indirectly the government could affect the value of its currency.

Fig. 1 - A shift in demand for USD

Figure 1 considers how an increase in demand for USD leads to an appreciation of USD. As demand for USD shifts from D₁ to D₂, the equilibrium in the foreign exchange market also changes from E₁ to E₂. That means that initially, one USD could get you 126 Japanese Yen, but now 1 USD can get you 128 Yen, two more Yen due to the increase in demand.

Aside from importing and exporting, currency value is affected by the demand for currency from investors. Let us assume that the Fed decides to increase the interest rate, which would result in the nation's banking system offering high-interest rates. In that case, foreigners will have increased demand for that currency to either deposit it in that nation's banks or purchase bonds because they will receive relatively higher interest payments than they could get with their domestic currency. Thus, demand for a currency rises when it has a relatively higher interest rate than other currencies, all else equal.

The flip side of interest rates is inflation. Investors seek higher relative interest rates but dislike inflation, defined as the rise in the general level of prices. Inflation reduces the purchasing power of money. When one currency has a higher relative inflation rate, it experiences reduced demand on the FOREX market. There is a direct relationship between interest rates and demand for currency, but an inverse relationship between inflation rates and demand for currency.

Inflation rates reduce interest rates. The interest rate adjusted for inflation is called the real interest rate, r. It is simply found by subtracting the inflation rate, , from the nominal (current) interest rate, i.

Investors demand currencies with higher relative real interest rates. The real interest rate within a country can be affected by both monetary policy and fiscal policy.

Effects of Changes in Policies on the Foreign Exchange Market

Economic policies tremendously impact the foreign exchange market in any country. Monetary policy refers to the central bank's control of the money supply to affect interest rates. The central bank uses monetary policy to cause the interest rate in a country to rise or fall to either discourage or encourage borrowing and spending.

The Fed pursues an expansionary monetary policy during a recession to expand the money supply and lower interest rates. This increases borrowing and spending within the country, boosting aggregate demand, and reducing demand for the currency from foreign investors. The currency's value will fall on the FOREX market due to reduced demand.

Conversely, when excessive inflation is in an economy, the government uses contractionary monetary policy to restrict the money supply and raise interest rates. This causes foreign investors to demand the currency more, which increases its value on the FOREX market.

Fiscal policy is the adjustment of government spending and taxation to affect aggregate demand. When the federal government increases its spending, that in turn causes an increase in aggregate demand - there will be more consumption of goods and services. This pushes up the rate of inflation. Higher inflation means a lower real interest rate, all else equal, which reduces foreign investors' demand for the U.S. dollar. The increase in aggregate demand also leads to an increase in imports. As imports increase, U.S. importers need to sell their dollars to buy foreign currencies to buy foreign goods. This leads to a drop in the relative demand for the U.S. dollar, decreasing the value of the U.S. dollar.

Effect of Changes in Economic Conditions on the Foreign Exchange Market

When a nation is experiencing increased aggregate demand, it tends to import more goods from other countries. This importing causes its currency value to depreciate. This helps achieve a natural balance in international trade: when a nation imports heavily, its currency value decreases, making it more attractive for other nations to buy its exports. A relative balance of trade should occur in the long run. As a nation imports more goods, its currency value decreases, making it more expensive to continue purchasing imports. To domestic consumers, it appears that the price of imports is rising. This is because it takes increasing units of that nation's depreciated currency to purchase one unit of the exporter's currency.

Conversely, when a nation is experiencing a recession, it imports fewer goods from other countries. This causes its currency to appreciate, as it puts less supply on the FOREX market to buy foreign currencies. As the currency appreciates, it can now buy more units of foreign currency, making it appear to domestic consumers that the prices of imported goods are decreasing.

Effects of Inflation on the Foreign Exchange Market

Investors dislike inflation. When a country is experiencing lower inflation, the country's currency will appreciate due to higher demand. Investors want to place their wealth in currencies of countries with low inflation. This can sometimes lead to the harmful phenomenon of capital flight, where wealth made in developing nations is quickly converted into well-established currencies like the U.S. dollar or Euro. This results in developing nations struggling to develop, as those who do become financially successful invest their money in wealthy nations.