Chip Taylor

Currency exchange rates

Hal Varian explains why they fluctuate.

How is that exchange rate determined? The basic force is good old supply and demand. If the demand for yen exceeds the supply at the current exchange rate, the cost of yen in terms of dollars will rise, and if supply exceeds demand, it will fall.

If the only reason to buy foreign currency was to use it to purchase foreign goods, international exchange would be pretty simple. Luckily for economists, the story is more complex.

People also want to acquire foreign currency to make investments. If America's interest rates are higher than Japan's, then Japanese investors will want to buy our bonds to take advantage of those higher rates. But to do so, they must first sell yen and buy dollars. This is where things get tricky.

Eventually, those Japanese investors will want to end up with yen. So they will care about not only the current interest rates on American bonds, but also the likely movement of exchange rates in the future.

What matters to them is the expected return denominated in yen, which involves both the rate of interest and the expected movement in exchange rates. This means the demand for yen will depend not only on the current exchange rate, but also on anticipations of future exchange rate movements.

The demand for currency to support international trade is pretty predictable, since the short-term trade patterns are reasonably predictable. It's the speculative demand that causes most of the short-term fluctuations, since foreign exchange traders have to make guesses about the future, and those guesses are constantly being revised.

As foreign exchange speculators change their views about the future, their demand for currency changes, resulting in exchange rate fluctuations.

On top of all this, central banks also intervene in foreign exchange markets for reasons that can be quite different from those of the other participants.

When I took international econ, this stuff made my head hurt.