What Determines A Currency’s Rate Of Exchange

Currency rates of exchange appear to be moving in response to so many factors that it makes it almost impossible to ascertain where the rate of exchange is likely to be headed. But rather than paying attention to the multitude of variables, it is more sensible to focus on the essential variable.

As far as the currency rate of exchange determination is concerned, this variable is the relative changes in the purchasing power of various monies. The relative purchasing power of various monies sets the underlying rate of exchange.

A price of a basket of goods is the amount of money paid for the basket. We can also say that the amount of money paid for a basket of goods is the purchasing power of money with respect to the basket of goods.

If in the US the price of a basket of goods is 1 dollar and in Europe an identical basket of goods is sold for 2 euros then the rate of exchange between the US dollar and the euro must be two euros per one dollar.

An important factor in setting the purchasing power of money is the supply of money. If over time the rate of growth in the US money supply exceeds the rate of growth of European money supply, all other things being equal, this will put pressure on the dollar.

Since a price of a good is the amount of money per good, this now means that the prices of goods in dollar terms will increase faster than prices in euro terms, all other things being equal.

As a result an identical basket of goods is priced now; let us say at 2 dollars, as against 2.5 euros. This would imply that the exchange rate between the dollar and the euro will be now 1.25 euros per one dollar.

Note the fact that changes in a local money supply affect its general purchasing power with a time lag means that changes in relative money supply affect the currency rate of exchange also with a time lag.

When money is injected into the economy it starts with a particular market before it goes to other markets — this is the reason for the lag.