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Factors which affect exchange rates

Exchange rates will be affected by a number of factors. We will consider these in relation to Australian dollars (Aus $).

Trade flows

A surplus of exports over imports for Australia (a trade surplus) will cause an increase in demand for Aus $ (overseas buyers need the Aus $'s to pay for the goods) and will therefore exert an upward pressure on the exchange rate. This is illustrated in Figure 1 below.

Figure 1 Australian trade surplus - impact on exchange rate

However, a deficit situation in which Australia imports exceed exports (a trade deficit) will cause an increase in supply of Aus $'s (Australian importers will need to supply Aus $'s to obtain the foreign currency required to pay for the imports). This will exert a downward pressure on the exchange rate as shown in Figure 2 below.

Figure 2 Australian trade deficit - impact on exchange rate

Capital flows / interest rate changes / speculation

In reality, capital flows exert a more important influence on exchange rates than trade flows. This is because the fund managers of international financial organisations and multinational corporations, and rich individuals, such as oil sheikhs, move more money around the globe on a daily basis than is accounted for by trade alone. They do this to take advantage of differences in relative interest rates and changes in exchange rates, or may be speculating on future movements in such variables. For the average person / IB student, shifting funds from one commercial bank to another may yield some benefit in terms of higher returns, but it is unlikely that the sums involved would be very great. However, for large institutions, with millions/billions of $, yen, euro etc. at their disposal, even marginal differences in interest rate returns will generate substantial sums of money.

Thus, remaining with the Australian example (see above), if interest rates were to fall below those in other major world economies, or international speculators were pessimistic about the future of the Australian economy, or suspected a large future depreciation in the Australian $, they might decide to sell their holdings of Aus $ and convert them into yen. This would increase the demand for yen, while increasing the supply of Aus $'s and cause a depreciation of the currency. This can be seen in Figure 3 below.

Figure 3 Australian capital outflows - impact on exchange rate

A currency crisis is caused when large numbers of speculators decide to sell their holdings of a currency at the same time, causing its price to crash.

In the case of the opposite scenario, i.e. an increase in Australian interest rates relative to others or greater optimism about the future of the Australian economy, speculators / fund managers might decide to move funds currently being held in yen into Aus $'s. This would have the reverse effect. The yen would depreciate in value as its supply increased and the Aus $ would appreciate as the demand for it increased (denoted by a rightward shift of the demand curve for Aus $'s).

Inflation

A higher rate of inflation in Australia than in other competitor countries would make Australian exports less competitive and may lead to less exports being sold, depending on the price elasticity of demand for exports. If this resulted in a worsening of the current account, the exchange rate would depreciate. With less demand for exports and imports becoming relatively more price attractive, the demand for Aus $'s would fall while the supply would increase. This is shown in Figure 4 below.

Figure 4 Impact of higher inflation on the exchange rate

The opposite might be the case, i.e. an appreciation of the Aus $, if the rate of inflation in Australia fell below that in other countries.

Inflation may also be a factor which currency speculators take into account when making decisions about buying/selling currencies. If a very high, uncontrollable rate of inflation was expected (a hyper-inflation), speculators might lose confidence in the currency and sell, causing a depreciation.

Use of foreign currency reserves

Exchange rates, whether fixed or floating, are usually influenced by the actions of governments. Thus, if the Australian government wished to exert an upward pressure on the Aus $ (perhaps as part of a monetary policy to lower the rate of inflation), they could buy Aus $'s on the foreign exchange market using their reserves of foreign currency. This would increase the demand for Aus $'s, causing an appreciation, while increasing the supply of other currencies, exerting a downward pressure on them.

If the Australian government wishes to exert a downward pressure on the Aus $ (perhaps to make exports more price competitive, increase aggregate demand and the level of employment), they would sell Aus $'s and buy other currencies. This would increase the supply of Aus $'s, thus causing a depreciation, while increasing the demand for other currencies.