Forex

Floating Exchange Rates

In a floating exchange-rate environment, the exchange-rate responds to many factors including the flow of imports and exports, the flow of capital, relative inflation rates, etc. Often, limits are placed on exchange-rate fluctuations according to government policies.

One factor affecting the exchange-rate between the Australian Dollar and other currencies is the merchandise trade balance. By definition, the merchandise trade balance is the net difference between the value of merchandise being exported and imported into a particular country. For example, consider the exchange-rate for AUD/USD. Australia imports products from the U.S. To pay for them, Australians need US Dollars; therefore, the Australian companies trade Australian dollars for US Dollars. On the other hand, because Americans desire Australian-made goods, they purchase Australian dollars to pay for Australian goods. The net effect is an increase in the supply of US Dollars and Australian dollars. The Australian demand for American goods and services contributes to the demand for US Dollars while American purchases of Australian goods and services contribute to the supply of Australian dollars. In this case, the net difference between Australian purchases of American goods and services, and American purchases of Australian goods and services, is the merchandise trade balance between the two countries.

The flow of funds between countries to pay for stocks and bonds purchases also contributes to the currency exchange-rate between currencies. In the near term, these capital flows are greatly influenced by yield differentials. All else being equal, the higher the yield on German securities compared to American securities, the more attractive German securities are relative to American securities. An increase in German yields would tend to raise the flow of U.S. dollars into German securities as well as decrease the outflow of Deutsche marks to American securities. Combined, this increased flow of funds into Germany would lower the value of the U.S. dollar and increase the value of the Deutschemark, therefore, the Deutsche mark to U.S. dollar ("DM/USD") ratio, as it is represented in the forex market, would decrease.

The rate of inflation is another factor influencing currency exchange-rates. Consumers try to avoid the eroding effect inflation has on their purchasing power. Consequently, goods from countries with a low inflation rate become more attractive than the goods from countries with higher inflation. In turn, the currency from the lower inflation country rises in value, while the currency from the higher inflation country falls in value. Both the inflation factor and the purchasing power of the currencies directly impact currency exchange-rates. For example, if the United States is experiencing lower inflation than its trading partner Germany, the DM/USD ratio rises to reflect the growing price level in Germany relative to the United States. This fact is rooted in the concept of a purchasing power parity, which holds that, over the long run, a currency exchange-rate adjusts to reflect the difference in price levels between countries.