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Why Do Exchange Rates Change?

Why Do Exchange Rates Change?

Most currencies are freely traded around the world on electronic exchanges, so as a result, we see constant – literally 24 x 7 – changes in exchange rates.

For most of us, the technical reasons why exchange rates change so often aren’t that important, but it’s always useful to have a bit of an understanding of the causes. It might help you make some informed guesses about the right time to buy a particular foreign currency, although you should always remember that even the experts get it wrong regularly, so these things are just guesses.

While there’s a lot of debate amongst economists (surprise, surprise) about what causes exchange rates to change, there is a consensus that the following six factors are important:

  • Inflation rates: generally, countries with lower inflation rates have higher-valued currencies
  • Interest rates: higher interest rates often mean that investors get a better return in one country than another, and so sometimes push the value of a country’s currency up compared to low interest countries
  • Current account deficits: a current account deficit means that a country is spending more on foreign trade (via imports) than it is earning (via exports), and so it will need to borrow from other countries to finance its deficit – and generally this means the value of its currency will decline
  • Level of public debt: if a country is running very large budget deficits, and borrowing to cover this cost, you will often see high inflation, which in turn will often mean a lower currency valuation.
  • Terms of trade: the terms of trade means the difference in the price of exports to the price of importants – a positive terms of trade means the prices a country gets for its exports is higher than the price it pays for its imports. Generally, the stronger the terms of trade, the stronger the currency, which has definitely been affecting the Aussie dollar in recent years
  • Stability and economic growth: finally, the level of political stability, and whether an economy is growing at all, matter to investors. Stable, growing countries are lower risk, and therefore tend to have stronger currency valuations.

One of the big problems faced by Europe, of course, is that some countries in Europe have these problems (eg Greece and Italy have huge public debts), while others like Germany don’t – but all of them share the same currency. That means that despite economic fundamentals meaning Greece should have a lower-valued currency, it is “stuck” with a higher valued Euro. European exchange rate changes are often harder to understand or predict as a result.

It’s interesting to note that Australia hasn’t always had a floating exchange rate. Up until 1983, in fact, the value of the Australian dollar was fixed against other currencies. Before 1971, the Australian dollar was regularly fixed as a percentage of the UK pound. After that, the US dollar was used, and on several occasions, a “basket of currencies” called a Trade Weighted Index was used. The Reserve Bank of Australia believes that the floating exchange rate in place since 1983 has been a big contributor to our economic success since then, as it “absorbs” shocks to the economy, such as when prices or demand for our commodity exports like coal or iron ore move suddenly.

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