What Drives Foreign Exchange Market Prices?

In a floating exchange rate environment, the foreign exchange market rate is affected by many factors which include the flow of imports and exports, capital flows and relative inflation rates. Limits are often placed on exchange rate fluctuations according to government policies, and currencies may also swing due to speculation and political uncertainty.

International Trade Flows

One factor that affects the exchange rate between the British pound sterling and other currencies is the merchandise trade balance. The merchandise trade balance is defined as the net difference between the value of merchandise being exported and merchandise imported into a particular country.

For example, consider the GBP/USD exchange rate. When U.K. companies import products from the United States, they need U.S. dollars to pay for them. Therefore, U.K. companies trade their British pounds for U.S. dollars.

On the other hand, when U.S. companies import goods made in the U.K., they need to buy British pounds to pay for these goods. The net effect is an increase in the supply of British pounds and U.S. dollars.

The U.K.’s demand for American goods and services increases the demand for U.S. dollars, while American purchases of British goods and services contributes to the increase in demand for British pounds. The difference between the value of American purchases of British goods and services and the British purchases of American goods and services is the merchandise trade balance between the two countries.

International Investment Capital Flows

The flow of capital between the two countries for the payment of stocks and bonds purchases also contributes to differences in the exchange rate between their respective currencies. In the short term, capital flows are strongly influenced by yield differentials.

All else being equal, the higher the yield on British interest bearing securities compared to equivalent American securities, the more attractive British securities will be relative to American securities. An increase in yields on U.K. bonds would tend to increase U.S. dollar flows into British securities and decrease the outflow of pounds into American securities.

Combined, the increase of capital flows into the U.K. would decrease the value of the U.S. dollar and increase the value of the pound sterling. As a result, the sterling versus the U.S. dollar or GBP/USD exchange rate ratio, as represented in the forex market, would increase. Hence more U.S. dollars would be required to buy one pound.

Inflation Rates

Inflation rates also affect foreign exchange market rates. Inflation is the reduction in purchasing power of a currency that occurs when a country’s money supply grows faster than its real Gross Domestic Product or GDP.

This situation results in more money chasing fewer goods, which then boosts the prices of those goods. Because exchange rates express one unit of the base currency in terms of the counter currency, differences in the inflation rate between two currencies shifts their relative value.

As an example, if the United States experiences a rate of inflation higher than Britain, this will put upward pressure on the GBP/USD exchange rate. This influence reflects the falling value of U.S. dollars relative to pounds sterling over time, as one pound can purchase more U.S. dollars because there are more U.S. dollars around compared with pounds.

The relative pricing of items in two countries can also affect their currencies’ exchange rate due to the concept of Purchasing Power Parity or PPP, where a particular good or basket of goods should theoretically have the same price in either country. Over a long term time horizon, the exchange rate should adjust to reflect the prevailing price levels in each country and move closer toward its PPP value.

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