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Forex, FX, Currency Trade: Strategy 101

An ‘exchange rate’ is the price of one currency in terms of another currency. The price of the currency is determined by the demand for and the supply of that currency in the FX market. Any change in the factors that determine the demand and supply will result in a change in the exchange rate. Of the theories advanced to explain the exchange rate, and changes in the equilibrium rate, the purchasing power parity (PPP) hypothesis is the longest standing. Under the PPP hypothesis, countries with relatively higher inflation rates can expect to have depreciating currencies. Among the various inadequacies of the hypothesis, perhaps the most critical shortcoming is that there are variables in addition to inflation that affects the value of a currency.

There is wide agreement that changes in the relative rates of growth in national incomes affect the exchange rate. There is disagreement, however, as to the nature of the effect. An increase in the relative rate of growth is likely to result in an increased demand for imports, which, all else being constant, would result in a depreciation of the currency. On the other hand, an increase in the growth rate may also result in an increase in foreign investment inflows, which would cause the currency to appreciate. Both mechanisms are likely to operate, with the balance between the two changing from time to time.

The interest rate differential between two countries is also important in determining the demand for and supply of the currency in the FX market. The effects of a change in the interest rate differential are ambiguous. It is important to determine whether the change is due to a change in inflationary expectations or a change in the real rate of interest.

In addition to the economic fundamentals, exchange rate expectations are critically important in determining the FX value of a currency. Expectations of depreciation will result in transactions that cause depreciations; in an appreciation is expected; then the appreciation typically will be experienced. The modelling of expectations is a particularly difficult task. Theoretically, expectations should be formed on the basis of the expected values of the fundamentals. In practice, on or two variables, such as commodity prices or the current account, may have a considerable impact on expectations.

At various times, another variable may be important in the FX markets: the government, through the Reserve Bank, may intervene directly in the FX Market to influence to value of the currency. In an attempt to increase the FX value of the AUD, the bank would sell foreign currency and buy the AUD; to reduce its value, the Bank would buy foreign currency.