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What Determines (Or Changes) Exchange Rates

You may know today’s dollar–euro exchange rate. But it will be something else next year. How do you predict what the exchange rate will be? Which factors are helpful in predicting the change in exchange rates?

Which exchange rate model to use?

You have two alternative ways of looking at exchange rate determination. First, you can apply a microeconomic approach to exchange rate determination and assume that currencies are exchanged just like oranges.

The question as to how many oranges do you need to buy one apple is fundamentally similar to the one as to how many dollars do you need to buy one euro. In the demand–supply model, the demand and supply curves shift for various reasons, some that relate to international trade and others that relate to international investment.

Second, you can focus only on international investment. In this case, you can think of yourself as an investor deciding between dollar- and euro-denominated securities (of similar maturity and risk). How do you decide between these securities?

The answer involves two factors: real interest rates associated with these securities and the expected change in the exchange rate. Keep in mind that monetary policies of two countries affect the real returns in this model, as well as your expectations regarding the future exchange rate.

Therefore, you need to keep a close eye on monetary policies of both countries, form your expectations regarding the real returns and the future exchange rate, sell one of the currencies, buy the other currency, and buy securities denominated in the latter currency. The currency you’re buying appreciates in the current (spot) foreign exchange market.

Are there any exchange rate prediction rules to live by?

Yes, certain generally accepted factors lead to predictable changes in the exchange rates. Two main factors are nominal interest rates and inflation rates. Higher inflation rates generally lead to higher nominal interest rates. If you ask why inflation rates increase, the major culprit, in this case, is an expansionary monetary policy, implied by higher growth in nominal money supply accompanied by declines in central banks’ key interest rates.

Therefore, all three factors (monetary policy, inflation rates, and nominal interest rates) are related and have a predictable effect on exchange rates. Most empirical evidence implies that expansionary monetary policies resulting in higher inflation rates and higher nominal interest rates lead to the depreciation of a currency.

In terms of real variables (variables that are adjusted for inflation), higher real interest rates and growth rates of real GDP (gross domestic product, or output of a country) lead to the appreciation of a currency.

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