How Exchange Rates Are Determined

The video opens by addressing the fundamental and complex question of how exchange rates are determined. It highlights that while a complete solution is elusive, economists understand the basic variables: inflation and interest rates. The challenge lies in knowing which variables are dominant and how they interact. The aim is to provide a basic understanding of exchange rate economics and why predicting movements remains difficult.

The video defines the exchange rate as the price of one currency expressed in another, which can be stated in two ways. A standard practice is to express how much foreign currency can be bought with domestic currency. For clarity, the video will consistently use 'appreciation' for an increase in a currency's price and 'depreciation' for a decrease.

Exchange rates are determined by supply and demand on decentralized foreign exchange markets (FX markets). These markets are largely hidden from consumers, who typically use banks as intermediaries. Like all markets, prices are set by supply and demand: increased demand leads to appreciation, and increased supply leads to depreciation.

The video explores what drives supply and demand for currencies, identifying arbitrage as a major factor. Arbitrageurs profit from price differences between countries. A currency's three functions—medium of exchange, unit of account, and store of value—are introduced as foundational to understanding exchange rate theories.

The first prominent theory, Purchasing Power Parity (PPP), focuses on money as a medium of exchange and unit of account. PPP suggests that prices in two countries should be roughly equal to prevent arbitrage opportunities. An example demonstrates how arbitrage through trade can lead to currency depreciation or appreciation until price parity is restored. However, scientific evidence for PPP is limited, especially for short-term fluctuations, due to trade barriers and non-tradable goods and services, though it shows more relevance in cases of hyper-inflation or over the long run.

The second major theory focuses on money as a store of value. It notes that bank deposits, rather than physical currency, are traded in FX markets and earn interest. The video acknowledges further complexities, such as investing in local stock or housing markets for higher returns, or profiting from currency appreciation itself. While these theories are not complete, they are considered building blocks for understanding exchange rate movements, with interest rates often explaining short-term movements and inflation for long-term movements.

The video warns against underestimating the complexity of FX markets, as speculators also play a significant role. Speculators attempt to predict the actions of arbitrageurs, seeking to profit from anticipated interest rate differentials or inflation changes. Because many participants engage in this, current exchange rates likely already reflect expectations about future interest rates and inflation in both countries.

A recap summarizes that exchange rates are the price of two currencies, driven by the supply and demand influenced by arbitrageurs and speculators. Arbitrageurs aim to profit from inflation and interest rate differences, but speculators often pre-empt these movements. The video concludes by suggesting that there's still much unknown about exchange rates and an opportunity to develop new theories, highlighting bidirectional influences between exchange rates, inflation, and interest rates, and the potential impact of behavioral finance on currency trading.