by Josef A

Created on: May 13, 2009   Last Updated: May 19, 2009

In general, there are two types of exchange rate regimes: A fixed or pegged exchange rate and a flexible or floating exchange rate. A fixed exchange rate establishes a stable exchange rate towards another currency, usually one of the major currencies such as the Dollar or Euro. This naturally implies that the exchange rate still varies against other currencies in case some countries maintain flexible exchange rates as a currency cannot be pegged against all currencies. Floating exchange rates are determined by markets through demand and supply. A natural hybrid occurs that allows exchange rates to float within a certain bandwidth.

Quite obviously, the case of floating exchange rates is the most interesting. The question what drives supply and demand in currency markets is of great interest for many market participants and affects a much greater proportion of the population than e.g. stock market prices do. This article will not impart you with knowledge on how to make exact predictions on exchange rate movements. It is extremely difficult to determine in which direction currencies move beforehand. Many experts of course try to do this, but with mixed success. There are, however, several factors that can explain currency rates. Bear in mind that markets in general look at future expectations, never at the past and the currency market is not any different.

Although there are concepts such as the Purchasing Power Parity (PPP) which help to determine whether a currency is fairly valued, the real driver of exchange rates in the long run is the economic strength of a country. The nominal exchange rate as we see it quoted at the markets is additionally quite sensitive to differences in inflation. Without going to much into economics, it should be kept in mind that in the long run all factors such as speculation, central bank interventions, and short term interest rates will not determine the exchange rate.

In the short run they very well do. The real interest rate, which is nominal interest rate minus inflation, is an important factor for market participants. If they expect a better return in a different country, capital is moved there and demand for the respective currency created which lifts the exchange rate. But again, real interest rates are in the long run determined by the economic performance of a country.

This is just a short example what actors in currency markets focus on. It is highly unpredictable on which economic news the currency traders focus more. The economy is hard enough to predict, but when a variable such as the exchange rate is determined by the the interconnection of two or more economies, it comes close to impossible. Confused? Well, that is what most people are if they want to predict currency exchange rates.

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