Economic Factors Determining Foreign Exchange Rates

What economic principles determine foreign exchange rates, and what causes them to change? This must be analyzed starting from the foreign exchange market.

The foreign exchange market, as the name suggests, is where currencies of different countries are exchanged. Exchange rates are determined here. Like other markets, the foreign exchange market is primarily governed by two major factors: the supply and demand of currencies, and the price of each country's currency, which is denominated in its own units.

Despite the various types of transactions in the foreign exchange market, the fundamental principle determining exchange rates remains the same. Many economists tend to explain the dynamics of the foreign exchange market using the relationship between supply and demand.

The American economist Paul Samuelson once used supply and demand curves to analyze the market determination of exchange rates. His example involved bilateral trade between the British pound and the US dollar. The demand for pounds in the US arises from the goods, services, and investments provided by the UK to the US. The US needs pounds to pay for these goods and services. The supply of pounds, on the other hand, depends on the goods, services, and investments provided by the US to the UK. The price of foreign exchange, i.e., the exchange rate, is set at the point where supply and demand reach equilibrium. The balance between the supply and demand of foreign exchange determines the currency's exchange rate. This supply and demand exist for every currency, coming from all corners of the world, and this multilateral exchange determines the global exchange rate system.