Foreign exchange rates change in value whenever the value of the underlying currencies fluctuates. When demand for a currency is greater than supply, the exchange rate will be higher. Conversely, when demand is lower than supply, the exchange rate will be lower. This does not mean that people do not want to have money, it simply means that they prefer other forms of wealth. In order to understand the behavior of foreign exchange rates, we must look at several factors.
Interest rates
The behavior of foreign exchange rates is based on a number of factors. During a recession, interest rates fall, which decreases the demand for foreign capital and lowers the exchange rate. Conversely, a rising value of the currency raises the demand for it and increases the exchange rate.
The behavior of FX rates has been a central concern of international finance since the collapse of the Bretton Woods peg system. This chapter reviews the empirical evidence that has accumulated since then, focusing on their behavior over the long run as well as over short periods. It begins by reviewing relevant economic theory and the historical antecedents of current exchange-rate research.
Interest rates and exchange rates are closely correlated. The central bank can influence interest rates to increase or decrease the value of a currency. For example, when the US government increases interest rates, more people will deposit their money in US banks, thereby increasing the demand for dollars. In addition, central banks can influence currency exchange rates and inflation through their interest rate policies. This would help explain the behavior of foreign exchange rates.
Government debt
The behavior of government debt and foreign exchange rates is closely related to one another. The rise in debt can create a gap between supply and demand, leading to wage suppression, financial repression, and currency depreciation. Rising debt can also result in a sharp decline in consumer spending. Manufacturers may shift their operations overseas, and farmers may hoard production or land. Workers, on the other hand, may become more militant.
Historically, people underestimated the benefits and negative consequences of rising debt. This miscalculation led to a global financial crisis. Rising government debt can hinder economic growth. This is because it creates uncertainty about the ability to pay off debts. This, in turn, can lead to behavior changes that reduce economic growth and increase financial fragility.
Speculation
Currency speculation involves buying and selling foreign currencies with the aim of profiting from changes in the exchange rates. It is also known as currency trading. The currency market plays a vital role in global business as it provides a convenient way to exchange funds. The evolution of the internet has even led to the growth of online Forex brokers, which have succeeded for regular investors to speculate in foreign currencies.
The current currency crisis has brought about record profits for currency speculators, who buy and sell currencies to profit from the fluctuations. Since the crisis began last summer, the amount of money made by currency speculators has skyrocketed. Malaysian President Mahathir Mohamad has blamed these investors and the financier George Soros for the situation, calling for new constraints on the activity.
Pegged exchange rate regimes
Pegged exchange rate regimes can influence the behavior of foreign exchange rates by affecting investment and productivity. Research has shown that countries that adhere to fixed exchange rates have lower inflation and higher productivity growth than those that are allowed to float their currencies. In addition, pegged exchange rates reduce the flexibility of the nominal exchange rate, leading to more volatility in output and employment.
Soft and hard peg policies differ in the amount of intervention the central bank can undertake in the foreign exchange market. Soft peg policies involve the central bank intervening in the foreign exchange market only when there is a risk of a rapid exchange rate movement. A hard peg, on the other hand, requires the central bank to set a fixed exchange rate for a country. This type of policy enables the central bank to monitor inflation and rates of return, but also increases the risks of large fluctuations.
Effects of macroeconomic announcements
Macroeconomic announcements can influence the foreign exchange market in a variety of ways. For example, they can influence order flow and exchange rates. But the effects of these announcements are not always apparent. This article will outline how to identify the effects of macroeconomic announcements.
Effects of macroeconomic announcements on foreign currency prices include appreciation and depreciation shocks. There are several types of announcements and each has its own impact. One type of announcement produces conditional mean jumps in exchange rates. This is known as the sign effect.
There is a prominent literature on the effects of news on currency prices. This literature is organized into two branches: the first-moment branch addresses the direction of price changes, while the second-moment branch considers volatility. This literature finds that macroeconomic announcements have significant effects on currency prices, but these effects are difficult to detect when the event occurs on a daily basis.