Introduction
In an economy, the exchange rate represents one of the most significant prices. It denotes the price of a nation’s currency in reference to another, thus responsible for converting prices denominated in a single currency to those subject to another (Robert, 2019). Financial experts and economists have yet to agree on a unified theory that defines the exchange rate. Thus, at least five exchange rate theory concepts can be regarded as traditional or modern.
Interest rate parity and purchasing power parity are among the theories that form the basis of traditional theories and play a crucial role in explaining exchange rate movements over long periods. On the other hand, modern theories emphasize the significance of international capital flow and offer explanations for short-period volatility in exchange rates and their overshooting over an extended period. This critical thinking essay analyses the effect of exchange rate fluctuation on the foreign exchange market. It does this by answering three questions based on four events and applying some of the theories mentioned above.
Increased U.S. Travel to Europe
Americans’ increased travel to Europe will lead to a decrease in the worth of the U.S. dollar and, thus, the need for a common currency. The currency exchange rate is influenced by the trade balance and its effect on the supply and demand of foreign exchange. When the trading account of a country does not net to zero. This occurs when exports and imports are not in equilibrium, and a country’s currency has a higher demand or supply. This affects the price of the specific currency on the global market. The exchange rate of currencies is stated in relative value: thus, a certain currency’s price is described in relation to another. For instance, 1 U.S. dollar equals 1.01 euros.
In practical terms, an American tourist exchanging dollars for Euros would buy 1.01 Euros for each dollar they sell (Ionel, Carmen, & Bogdan, 2018). A currency’s demand determines its relative value, which in turn influences trade. With increased American travel to Europe, Europe will need to buy more dollars relative to the euros it sells.
Europe’s demand for the dollar will surpass America’s demand for the Euro, which will lead to a decline in the dollar’s value. This will have a subsequent effect in line with the theory of purchasing power, which states that the prices between two countries should be at equilibrium. In a scenario like this, where demand and supply have led to a decline in the dollar’s value, the higher exchange rate will impact trade between Europe and America. Specifically, the rise in the exchange rate will lead to increased prices of services and goods in America. A demand for a common currency is inevitable to prevent the effect that demand and supply have on the two currencies.
Saudi Investment and Stock Markets
The purchase of large amounts of U.S. stocks by Saudi investors will increase the demand for the U.S. dollar, thus increasing its value. According to Ding & Yannick (2022), “when there is a rise in the domestic stock market, investors gain confidence that the country’s economy is also rising, resulting in foreign investors’ increased interest and an increased demand for the domestic currency” (p. 3). Therefore, the purchase of large amounts of U.S. stocks by Saudi investors will result in increased interest rates and, consequently, a higher exchange rate of the U.S. dollar, following the strengthening of the U.S. dollar.
The relationship between interest rates and exchange rates is well understood. Correspondingly, a well-established approach exists for the prevailing link between interest rates and stock market performance (Nick, 2022). From an asset pricing perspective, the connection between equity returns and the exchange rate is determined by the existing covariance between the risk in the exchange rate and returns and stock markets.
When a foreign country, such as Saudi Arabia in our case, experiences a rise in its stock market performance relative to its home country, such as the U.S., this encourages portfolio investors to sell foreign currency stocks due to the overweight nature of their investment in foreign currency equities. The investors will then sell the proceeds of the foreign currency for local currency, which guarantees a neutral position.
Simultaneously, this causes foreign currency depreciation when the foreign stock market outperforms the domestic market. Thus, there is a clear nexus of volatility between the two markets, and consequently, a positive association between the exchange rate and the stock market, as one market’s risk is transferred to the other. The result will thus be an increase in demand and value of the U.S. dollar.
Global Interest Rates
Interest rates play a crucial role in determining a currency’s value. They refer to the sum of money a borrower is obligated to pay a lender to hold their money. There is a relationship between interest rates and the exchange rate, evident in price fluctuation in foreign currencies due to vacillations in interest rates. High interest rates could imply a high return on investment and thus attract investors. Therefore, a sudden increase in interest rates due to a rise in global rates will result in a rise in the value of the United States dollar, as investors seek high returns and want to hold their money in dollars.
In an ideal world example, an interest rate increase attracts investors to a currency. With the attraction of more investors, the currency’s demand increases, and its value rises. These investment flows in economics are referred to as hot money flows and are expected to result in an increase in investors’ money, in accordance with the interest rate parity theory. The theory states that “the difference in interest rates between two countries is equal to the variance between the forward exchange rate and the spot exchange rate” (Ionel, Carmen, & Bogdan, 2018, p. 6). Thus, with a high-value U.S. dollar, they would increase their cash upon exchange back to their country’s exchange rate.
Economic and Political Instability
When other countries are less economically and politically stable than the U.S., investors tend to seek a safe-haven currency in which to park their funds. Notably, political elections tend to have a significant impact on a nation’s currency (Ibrahim & Bruno, 2021). Traders tend to view elections as isolated occurrences of possible uncertainties and instability, which parallels volatility in the specific country’s currency value.
Moreover, political personalities or parties are viewed as responsible for promoting a country’s economic growth and thus enhancing a country’s currency’s relative value. Thus, if other countries are experiencing economic and political turmoil, this will result in a loss of investment. They would thus seek to invest their funds in the U.S., a safe haven. This would impact the foreign exchange market, as the investment of funds in the U.S. would lead to an increase in demand and the value of the U.S. dollar, in line with the monetary approach theory.
This theory asserts, “increase of the supply of money results in a cheaper domestic currency than its foreign exchange” (Ibrahim & Bruno, 2021, p. 139). The domestic currency is that of the uncertain countries, whose political and economic turmoil has resulted in an increased money supply. The investors would have their funds in the U.S., a foreign country, to prevent their money from becoming cheaper in their domestic countries.
Conclusion
The four events described are currently impacting foreign exchange markets, with three of them specifically leading to a stronger U.S. dollar. First, Americans traveling more to Europe will increase the demand for the Euro. However, demand for the U.S. dollar is boosted when Saudi investors buy large quantities of U.S. stocks. The dollar’s value also rises sharply when U.S. interest rates increase relative to global rates, making dollar assets more attractive.
Finally, global economic and political turmoil encourages investors to seek a safe haven, which significantly increases the demand and value of the U.S. dollar. Pegging a currency means having a fixed exchange rate; in this case, the value of the exchange rate would remain unchanged. Thus, the events discussed above would not affect foreign exchange markets if the currency were pegged to a stable value. A floating exchange rate system would modify the analysis; in this case, the specific country’s central bank would have intervened to alter the loss in the value of the specific country’s currency in relation to the U.S. dollar. This intervention would have altered my analysis to incorporate the effect of the alteration on the events.
References
Ding, D., & Yannick, T. (2022). Exchange rate elasticities of international tourism and the role of dominant currency pricing. International Monetary Fund, 2-30. Web.
Ibrahim, A. N., & Bruno, S. S. (2021). The impact of a political shock on foreign exchange markets in a small and open economy: A dynamic modelling approach. Journal of Central Banking Theory and Practice, 137-152. Web.
Ionel, B., Carmen, T. S., & Bogdan, N. F. (2018). Exchange rate effects on international commercial trade competitiveness. Journal of Risk and Financial Management, 2-7. Web.
Nick, L. (2022). Investopedia. Web.
Robert, C. (2019). International Economics. Cengage Learning.