By Dr Frank Shostak
Often various factors are perceived to be important in determining a currency rate of exchange. For instance, for some commentators an increase in the government foreign debt is regarded as pointing to a likely deterioration in economic fundamentals ahead. This provides the rationale for the selling of the currency of concern.
For many economists the state of the balance of trade is a key factor in the currency exchange rate determination. On this way of thinking, all other things being equal, an increase in imports, which leads to a trade deficit, gives rise to an increase in the demand for foreign currency. To obtain the foreign currency importers sell the domestic currency for it. As a result, this causes a strengthening in the exchange rate of the foreign currency against the domestic currency i.e. more domestic money is sold per unit of a foreign money.
Conversely, all other things being equal, an increase in exports leads to a trade surplus. Once exporters exchange their foreign currency earnings for domestic money this sets in motion a strengthening in the domestic money exchange rate against the foreign money. (More foreign money is sold per unit of domestic money).
Alternatively, consider the case when the central bank tightens its interest rate stance. The increase in the domestic interest rate, all other things being equal, attracts foreigners demand for domestic money. (The holders of the foreign currency are now exchanging it for the domestic currency that is going to be placed in the domestic currency deposits in order to earn higher interest rates). Consequently, this lifts the price of the local currency in terms of foreign currency.
It would appear that various factors such as the government debt, the interest rate differential, the state of the economy and the balance of trade are important factors in the currency exchange rate determination.
We can also add to these various psychological factors that would appear to be important in the currency exchange rate determination. Thus, a change in individuals’ perceptions regarding the state of the economy is likely to influence the currency rate of exchange.
Rather than focusing on many factors, it would make more sense to identify the key or the essential factor that determines the currency rate of exchange. We suggest that what matters here is to identify the essence that dictates the currency rate of exchange determination.
The relative purchasing power of money – the essence of the exchange rate
We suggest that the essence of the currency exchange rate is the relative purchasing power of various monies.
Now, a price of a basket of goods is the amount of money exchanged for this basket. We can also say that the amount of money exchanged 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 is one dollar and in the Eurozone an identical basket of goods is sold for two euros then the rate of exchange between the US dollar and the euro is likely to be two euros per one dollar.
An important factor in setting the purchasing power of money is the supply of money. Now, let us say that over time the growth rate in the US money supply exceeds the growth rate of European money supply, all other things being equal.
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 two dollars against the one dollar previously whilst in the Eurozone 2.5 euros against 2 euros previously.
This would imply that the exchange rate between the US dollar and the euro should be now 1.25 euros per one dollar and not 2 euros per one dollar.
Another important factor in driving the purchasing power of various moneys and the exchange rate is the change in the demand for money. For instance, with an increase in the production of goods the demand for money is likely to follow suit.
The demand for the services of the medium of exchange is likely to increase since more goods are now going to be exchanged. As a result, for a given supply of money, the purchasing power of money is going to strengthen, all other things being equal. Less money will be chasing more goods now.
Deviation of the exchange rate from the relative purchasing power sets in motion arbitrage
Any deviation of the exchange rate from the rate as implied by the relative purchasing power of money is likely to generate profit opportunities, which is going to undo the deviation.
For instance, the deviation could emerge because of the market response to the trade account data or because of a change in the interest rate differential in the domestic economy versus other economies. We suggest that these deviations are likely to set in motion profit opportunities, which are going to undo these deviations.
Let us say that the Fed raises its policy interest rate while the European central bank (ECB) keeps its policy rate unchanged.
Now, if the price of a basket of goods in the US is one dollar and in Eurozone the price of identical basket is two euros, then according to the purchasing power framework the currency rate of exchange should be one dollar for two euros.
Because of a widening in the interest rate differential between the US and the Euro-zone, an increase in the demand for dollars pushes the exchange rate in the market towards one dollar for three euros. (The holders of the euros are now exchanging more euros for dollars that are going to be placed in the dollar deposits in order to earn higher interest rates).
Note that the dollar is now overvalued versus the exchange rate as implied by the relative purchasing power of the dollar versus the euro (it should be two euro to one dollar and not three euro to one dollar).
In this situation, it will pay to sell the basket of goods for dollars then exchange dollars for euros and then buy the basket of goods with euros – thus making an arbitrage gain.
For example, individuals could sell a basket of goods for one dollar, exchange the one dollar for three euros, and then exchange three euros for 1.5 basket, gaining an extra 0.5 of a basket of goods. (Please note that the price of the basket of goods in the Eurozone is 2 euros)
The fact that the holders of dollars increased their demand for euros in order to profit from the arbitrage is going to make euros more expensive in terms of dollars i.e. more dollars per euro – pushing the exchange rate in the direction of one dollar for two euros.
We suggest that arbitrage is always set in motion once the rate of exchange deviates, for whatever reasons, from the rate of exchange as dictated by the relative purchasing power of monies.
Summary and conclusion
We suggest that the key factor in the currency exchange rate determination is the relative purchasing power of various monies.
If for whatever reasons the market currency exchange rate deviates from the exchange rate as implied by the relative purchasing power of various monies this activates an arbitrage, which works towards the convergence of the exchange rate towards the relative purchasing power of monies.
