Page 190 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes currency, the company has converted the amount of profits in its local currency. If the euro
appreciates against the local currency, then the amount of profits when converted into euros
will be less.
16.3 Determinants of Exchange Rate

Many theories there have been written in respect to the main determinant of future exchange rates.
Although the majority of these theories give adequate reasons in order to explain what actually
determines the rates between the currencies, we can argue that there are many factors that may cause
a currency fluctuation. Consequently, there is little that can be alleged in respect to the theory that
better answers the question of what finally determines the exchange rates.
Here below, we will refer to the main theories regarding the determinants of the exchange rates.
1. Supply and Demand
As stated earlier, the exchange rate, just like commodities, determines its price responding to
the forces of supply and demand8. Therefore, if for some reason people increase their demand9
(shift of the curve from D to D1) for a specific currency, then the price will rise from A to B,
provided the supply remains stable. On the contrary, if the supply10 is increased (shift of the
curve from S to S1), the price will decline from A to C, provided the demand remains stable .
Any excess supply (above the equilibrium point) or excess demand (below the equilibrium
point) will increase or decrease temporarily foreign currency reserves accordingly. Finally, such
disequilibrium situations will be eliminated through the pricing, e.g. the market itself.
2. Purchasing Power Parity (PPP)
By definition the PPP states that using a unit of a currency, let us say one euro, which is the
purchasing power that can purchase the same goods worldwide. The theory is based on the
'law of one price', which argues that should a euro price of a good be multiplied by the exchange
rate (€ /US$) then it will result in an equal price of the good in US dollars. In other words, if we
assume that the exchange rate between the € and US $ states at 1/1.2, then goods that cost € 10
in the EU should cost US$ 12 in the United States. Otherwise, arbitrage11 profits will occur.
However, it is finally the market that through supply and demand will force accordingly the
euro and US dollar prices to the equilibrium point. Thus, the law of one price will be reinstated,
as well as the purchase power parity between the euro and US dollar.
Inflation differentials between countries will also be eliminated in terms of their effect on the
prices of the goods because the PPP will adjust to equal the ratio of their price levels12. More
specifically, as stated in their book (Lumby S. & Jones C. 1999) "the currency of the country with
the higher rate of inflation will depreciate against the other country's currency by approximately
the inflation deferential".
In conclusion, it can be argued that the theory, although it describes in a sufficient way the
determination of the exchange rates, is not of good value, mainly because of the following two
disadvantages. Firstly, not all goods are traded internationally (for example, buildings) and
secondly, the transportation cost should represent a small amount of the good's worth.
3. The Balance of Payments (BOP) Approach
The balance of payments approach is another method that explains what the factors are that
determine the supply and demand curves of a country's currency.
As it is known from macroeconomics, the balance of payments is a method of recording all the
international monetary transactions of a country during a specific period of time. The transactions
recorded are divided into three categories: the current account transactions13, the capital account
transactions14, and the central bank transactions15.
The aforementioned categories can show a deficit or a surplus, but theoretically the overall
payments (the BOP as a whole) should be zero - which rarely happens.
As stated earlier, a currency's price depreciation or appreciation (the change in the value of
money), directly affects the volume of a country's imports and exports and, consequently, a
likely fluctuation in the exchange rates can add to BOP discrepancies.

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