Short Term Exchange Rates, Determined by Supply and Demand
As with any other price in an economy, exchange rates are determined by supply and demand, specifically the supply and demand for each currency. However, we need to understand what determines the supply and demand for a specific currency.
Demand for a Currency
The supply of a currency on the OTC exchange market is determined by the following:
Demand for goods, services and investments priced in that currency. If an investor wishes to buy bonds, oil or any “goods” from a particular country, the financial transaction is usually done in the local currency from where these goods and services are being provided. If total expenditures, by external countries, on these items increases, then logically, the demand for the local currency will also increase.
Forex Speculative Investors
If investors believe that a countries economy is growing, then it follows that, the value of the local currency will increase in value, in the future, If that currency is purchased at today’s prices and the value increases, it can be sold back, at a later date at a higher value, so yielding profits.
Central banks – Central banks will buy up a foreign currency to affect the exchange rate.
Currency supply is affected by the following
Demand for goods, services and investments priced in a different currency. If I want products or services from a particular country, I will need to pay in that countries currency. To do this, an investor will have to pay in their own denoted currency, such as Euros, Yen or U.S.D.
The same works in reverse. If an investor believes, a currency will drop in value in the future, they will undertake to sell off their currency immediately (supply them to the market). With a view to buying them back at a later time at an even lower value, speculating that the currency will rise again.
Central banks through increases in the money supply.
What Should a Currency Be Worth?
If investors can affect both the supply and demand for a currency, they ultimately affect the price. Thus does a currency have an intrinsic value relative to another currency? Is there a level the exchange rate should be at?
There is an approximate level to which a currency should be worth between two countries, see “The Big Mac index” Purchasing Power Parity (PPP). The exchange rates should reflect the level at which a basket of goods costs the same in two currencies.