The Foreign Exchange Market

The foreign exchange market is a truly global market in which the economic conditions of all countries matter. The four key factors affecting the foreign exchange markets are: (1) relative prices, (2) relative interest rates, (3) relative economic growth rates, and (4) the current account balances of each country. Although each of these is discussed separately, it is important to note that they can work against each other as opposing forces. As a result, a country with low inflation might have a weak currency because it has a large current account deficit or low interest rates.

Relative Prices These prices consider inflation rates of the countries in question. A high inflation rate is a common scourge for economies across the globe. Those economies with lower and more stable rates of inflation have stronger currencies. Therefore the acceleration of U.S. inflation rates would lead to a lower value of the dollar vis-à-vis other currencies. In contrast, declining rates of inflation would lead to a strong dollar relative to other foreign currencies. Inflation hurts the economy not only because purchasing power is lost, but also because inflation is often unstable and unexpected, and it distorts investment decisions.

In late 1997 emerging market economies in Southeast Asia began to face deflation for a variety of reasons including bank failures, stock market crashes, and weak economies. Deflation—outright falling prices—is as bad as inflation because it distorts purchase and investment decisions. It would not help the country's currency value. One example to the contrary is Japan. The Japanese economy has suffered steady deflation for seven years from the late 1990s through 2005 (with no end in sight), yet it continues to have a strong currency. The strong currency is due to the country's huge current account surplus—another factor that must be taken into account and is discussed next.

Relative Interest Rates These rates reflect the investment opportunities of various countries in question. The currency of a country with high interest rates appreciates relative to other currencies. Higher interest rates mean a higher rate of return on investments. This was evident in the early 1980s when high interest rates in the United States relative to other countries led foreign investors to buy U.S. Treasury securities. This demand for Treasury securities led to a demand for dollars, and the value of the dollar soared in the early 1980s before peaking in the first quarter of 1985. The flip side is that low interest rates in the United States, compared with the interest rates in other countries, will depreciate the value of the dollar. The Federal Reserve eased credit conditions significantly between 2000 and 2003, lowering its federal funds rate target by 550 basis points from 6.5 percent to 1 percent. The euro/dollar exchange rate bottomed out in 2000-2001 and appreciated 57 percent between mid-2001 and December 2004. During this period, the European Central Bank rate was higher than the fed funds rate.

Relative Economic Growth Rates These rates consider relative demands for goods and services. Strong economic growth in a country may actually lead to a weaker exchange rate for that country's currency because strong economic growth is associated with healthy personal income growth. Whenever consumers have more income to spend, they want to consume more. Once consumers have increased their demand for goods and services, some of that demand is satisfied by a greater demand for imported goods, which in turn indirectly leads to a greater demand for a foreign currency wherever those imports are bought. This causes a decline in the value of the home currency.

If foreign countries are not growing as rapidly, their demand for imports (another country's exports) will not be as strong. Consequently, an offsetting demand for the currency will not arise.

Current Account Balance A country's account balance also affects the foreign exchange market. The current account includes the balance in trade and services (defined in greater detail in Chapter 5). Running continuous current account deficits weakens a country's currency. For example, a current account deficit in the United States means that we are buying more goods and services from foreign countries than they are buying from us. If we demand more imported goods and services, we also have a larger demand for foreign currencies. A greater demand for foreign currencies weakens the value of the dollar. The U.S. economy has been much stronger than the Japanese economy between 1990 and 2005. However, the U.S. current account deficit grew ever larger while the Japanese surplus skyrocketed. Consequently, the dollar depreciated over this period while the Japanese yen appreciated.

Prices, interest rates, economic growth, and the current account balance are all interrelated, making it difficult to isolate which of these factors is at play when the value of the dollar is moving at any given moment. The real world does not hold all factors constant, as economists would prefer, and this makes analysis tougher.

The foreign exchange markets are further complicated by political factors that weigh in a currency's valuation. Historically, political instability in any part of the world generally favored the U.S. dollar because the United States was considered a highly stable country, politically and economically. Since 2000, however, the winds have changed for a variety of economic and political reasons. Now investors also consider the euro, the yen, and the Swiss franc as alternative currencies in times of turmoil.

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