Globalization

Unit 5: Exchange Rate Systems

Part 6: Market-Driven Flexible Exchange Rate Determination

When the United States ended gold convertibility in 1973, its European trading partners were not particularly happy. Because of the US’s huge current account deficit, the dollar naturally fell against other currencies. That put foreign exporters at a distinct disadvantage: as their currencies appreciated against the dollar, their goods became more expensive for US consumers. The US was accused of “exporting inflation”—it was making its trading partners pay for vicissitudes of the dollar’s value. That was the price that Europe had to pay for the switch to market-driven exchange rates.

Supply and demand. As we might guess, the theory of market-driven exchange rates is fairly simple: the exchange rate is driven by supply and demand. That’s fine. But money is different than other goods in the sense that there are few production costs for it—the “actual” costs for printing hard currency are small; the cost of money itself is the interest rate. Unlike bicycles, computers or pizza, in other words, the supply curve for currencies is not driven by the actual cost of producing a unit of currency.

So what drives supply and demand? Well, interest rates matter, as we’ve seen, but what else? To name a few:

Productivity and rates of return on investments. The real answer to this question is very complicated. But, as a first approximation, it’s not unfair to say that in market-driven exchange rate systems, the exchange rate is a function of a country’s productivity and rates of return on portfolio investment relative to others—at least in the near term. For example, if country A can produce cars much more efficiently than its competitors, then demand for that country’s currency will go up, since in order to buy the cars foreigners have to purchase country A’s currency. Likewise, if stocks or bonds in country A have a high expected rate of return (perhaps because of their productivity), then demand for the currency will, likewise, go up.

No precedent. While this is an oversimplification, it does explain some exchange rate movements. For example, the yen’s appreciation against the dollar was due in part to Japanese productivity in the late 1970s. The appreciation of the dollar against almost all world currencies in the ’90s was due to high expected rates of return on US investment. The bigger problem with understanding market-driven exchange rate systems is that we have no real contemporary precedent for them. Although currencies have nominally floated against one another since the 1970s, this has been a managed float: when any of the world’s major currencies threatens to change value quickly, central bankers from its trading partners usually intervene to keep the changing currency within an informally defined trading range. For example, following the September 11th terrorist attacks, central bankers feared financial instability from “panic” sales of US investments, so they agreed to buy up dollars from those wanting to sell in order to show support and commitment to the US economy and the dollar’s value.

VIDEO: Central Bank Intervention after 9/11 clip 1

VIDEO: Central Bank Intervention after 9/11 clip 2

Impact of inflation rates. An important longer term explanation for exchange rate determination is the inflation rate differential between nations. If a nation experiences higher rates of inflation than its trading partners, its products will become relatively more expensive and demand for its currency over time will fall. In the days of fixed exchange rate systems, such differentials were part of the natural adjustment process toward balance trade, as we have seen; but in a flexible rate world such inflation will work to perpetually undermine a currency’s value if left unchecked.

VIDEO: S&D of Exchange Rates, Major Determinants of Rates

VIDEO: Pounds vs. Dollars Supply and Demand Example