Forex Trading – The Determinants of Exchange Rates

Currencies' trading involves trillion of US dollars everyday. Currency exchange transactions are facilitated by banks and financial institutions. There are lots of factors which can decide or influence the changes of exchange rates. These factors can be categorized under market forces and government intervention.

Dual forces of Supply and Demand

The exchange rates are impact by the economic events affecting the supply and demand for currencies. First, trade flow between countries reflects the demand of goods and services for a country which also indicates the demand for the country currency to conduct trade.

Second, government policy such as tax policy, labor law and tariff may influence the changes in supply and demand for currency.

Third, other economic conditions such war, political instability and a real price "shock" will affect forex too. An example of a real price "shock" is the increase of oil price drastically. Therefore, changes in any of these real economic factors will cause the supply and demand for currency value to shift and affects the exchange rates.

Government Intervention

Government can influence changes intentionally and unintentionally. Government can intervene in currency market through Central Bank buying or selling home currency in exchange of its foreign currency reserves. Government fiscal and monetary policy may unintentionally trigger the movement in forex market.

Type of Exchange Rate Regimes

There are 3 types of exchange rates regimes: fixed exchange rate, free float and managed float. In fixed exchange rate, the government decides a fixed exchange rate and the system allows trade activities during volatile market situation as uncertainty and risk are minimized. However, continuous monitoring required government to set away reserves. In free float system, forces of supply and demand determined the exchange rate and do not require government intervention. This system invites speculation that is volatile and unstable. In managed float system, government intervene to ensure the exchange rate remain within a specified range. Central Bank will buy or sell home currency to ensure the exchange rate is within an allowed floating range.

In the short run, government fiscal policy and monetary policy may affect the dual forces of supply and demand thus determined the exchange rates. However, no policy can overtake market forces in the long run.