How is an exchange rate decided?

Answer 1

Exchange rates are set via two different ways: fixed rate and floating.

Fixed rates are set at... errr... a fixed rate. Usually through a policy called dollarization. This is where every currency unit is backed by an equal amount of US dollars in reserves. For example, if a Smolgarian Ziggli (I made that up) is fixed at 4.0 Ziggli to the US dollar and the Smolgarian Central Bank has printed 400 billion Ziggli, they need to have 100 billion US dollars to dollarize. So if somebody buys/sells a ziggli for dollars, the central bank can accomodate the sale with no impact.

The floating exchange rate is much more difficult. The exchange rate is set by a triangle arbitrage called the "interest rate arbitrage theory". The monetary system is all intertwined through three legs.

Leg 1. Current Exchange rate. Currently there are 116 Japanese Yen to the dollar (around that, but just humor me for now if I'm off a bit).

Leg 2. There are interest rates. You can deposit the Yen in Japanese accounts for essentially zero interest (due to extremely low interest rates in Japan - which actually went negative for a while, but I digress). For argument's sake, let's say 0%. In the US the interest rates for a 1 year CD are about 5%.

Leg 3. Currency futures. Currency futures perfectly align what the future exchange rate should be. Otherwise, there is an arbitrage opportunity. For example, if I borrow 116m Yen, turn it into US$ 1m dollars and deposit it at 5%, wait one year, then exchange it back to yen to pay off the 116m yen debt. If the Japanese yen currency markets did not factor in a 5% depreciation of the yen, you would have an arbitrage opportunity. That is, you could borrow an infinite amount of money in Japan, deposit it in the US and make an infinite amount of profit.

I live in Singapore and the same thing applies to me. Local CDs earn about 2-3% compared to my US dollars which earn about 5%. Why don't I shift all my money to the US? Because the Singapore dollar is expected to strengthen against the US dollar about 2-3% per year. Hence, I've got no reason to shift my money out of Singapore.

Now, the currency futures market is mostly reactive to the interest rate market - which means most of the changes in interest rate expectations (disparity in borrow/lend rates, changing interest rate curves and change in local inflation) mostly affects the exchange rate.

The above is a function part of exchange rate dynamics. But why 4.0 Ziggli instead of 4,000? The PPP theory (as previously described) does partially explain this. However, it breaks down for countries that are dollarized (which used to be a huge amount of countries after the 1997 Asian currency crisis and the Argentinian financial meltdown in the 1990s).

Answer 2

exchange rate is basically decided by the purchasing power parity theory - interdependant on may factors such as GDP,
Political stability, economic conditions etc

Answer 3

it really is a organic call for provide ECONOMICS, the marketplace makes a decision it, meaning the consumers and sellers in the marketplace opt for it. If the consumers OF AN forex > than the sellers OF THE forex : THE replace price depreciates. If the consumers OF AN forex < than the sellers OF THE forex : THE replace price appreciates. The critical economic employer of the rustic is the only service of overseas forex echange in the rustic. It reflects the replace price depending on the abode forex's call for and provide vis a vis the overseas forex echange. If call for for INR is weak as adversarial to USD, INR will depreciate, USD will celebrate with, and this may be pondered in the Indian replace price. If call for for Euro is weak adversarial to greenback (USD), INR will appreicate adversarial to the Euro and Euro will depreciate in India.

Answer 4

5 bearded guys from the ghetto sit together every saturday night around a table in a dingy room and they decide.