Speculators set exchange rates
Speculators are often accused of causing the woes of a countrys economy, they cause companies to go bust when they loose confidence unecessarily, and they push exchange rates in the 'wrong' direction or cause a 'readjustment' into a crisis. How much impact do they really have?
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Self fulfilling prophecy
Participants in a foreign exchange market expect a certain price so they act on their expectations, this will lead to the price converging on the expectations of the speculators. [http://www.philadelphiafed.org/research-and-data/publications/business-review/1997/september-october/brso97gh.pdf Gregory P. Harper, ‘What determines the Exchange Rate: Economic Factors or Market Sentiment?’ Business Review, (oct. 1997), p.22.]]
These expectations are still likely to be in line with the economy itself, so it is the fundamentals of the economy that effect the speculators not the other way around.
The speculators may well know from the fundamentals what way the currency should be going but won’t know when. Speculators can therefore determine the timing, and turn a slow depreciation/appreciation towards the market rate into a stampede. [http://www.philadelphiafed.org/research-and-data/publications/business-review/1997/september-october/brso97gh.pdf p.23.]]
Currency carry trade
Investors borrow in a currency that has a low interest rate and then lend it in a currency that has a high interest rate, the effects of leverage (using mostly borrowed money) means that these can be very large trades and distort the exchange rate markets. [http://www.investopedia.com/terms/c/currencycarrytrade.asp]]
Balance of Payments
If country A has a balance of payments deficit with country B it is importing more goods and services than it is exporting so country A is paying more of country B’s currency than B is of A’s currency so there is higher demand for B’s currency so the B will rise against the A. This is because exporters prefer to be paid in their own currency so as avoid the costs of converting the currency (passing it on to the buyer). [http://www.gwu.edu/~ibi/minerva/Spring1998/Jose.Adriano.Pereira/Jose.Adriano.Pereira.html José Adriano Pereira ‘Balance of Payments & Exchange Rates’, (Spring, 1998)]]
If a country is running a deficit then it is likely to wish to devalue its currency to correct this deficit.
foreign direct investment
if there is foreign direct investment in a country then its currency will rise as the investment needs to be in that country’s currency thereby increasing demand for the currency. As the currency rises the level of FDI will decrease as it becomes more costly to invest as the currency of the company’s home country will be depreciating. [Matteo Iannizzotto, Nigel J. Miller, 'The Effect of Exchange Rate Uncertainty on Foreign Direct Investment in the United Kingdom.' http://www.york.ac.uk/depts/econ/profiles/details/ozkang/ozkang_paper9.pdf%5D%5D
This may well be caused by the perception FDI gives that a country’s economy is stable and strong so if a firm thinks an economy is worth investing in then speculators will think it’s worth buying its currency.
Government and Central bank intervention
It is quite possible for governments to set the exchange rate. If there are political decisions to not allow the currency to float freely then politicians make the choice to restrict their possible use of monetary policy (interest rates) and mobility of capital. So the currency may be pegged to a basket of other currencies like the Chinese yuan. Countries that do allow the currency to float may restrict this by having their central banks buy and sell currencies, or use interest rates to keep their exchange rate within a certain range. This is what the Bank of England did to keep the sterling within the exchange rate mechanism. [Ben Carliner, What Determines Exchange Rate Regimes? The Trilemma and its Consequences, Economic Strategy Institute, (Aug., 2005) http://www.econstrat.org/images/ESI_Research_Reports_PDF/what_determines_exchange_rate_regimes.pdf%5D%5D
As the sterling falling out of the ERM demonstrated if the speculators pile in against an exchange rate that is kept within certain bounds by the central bank or government of a country then the speculators will likely win.
Condition of the economy
it is the fundamentals of the economy that determines the exchange rate, the country’s output and money supply. In this Monetary Model it is the relative prices for goods in two countries. So if goods and services the same in country A and country B then the countries will be at parity at 1A:1B however if the average price of goods/services doubles in A (inflation) while prices in B remain the same then the value of A’s currency will fall to 2A’s to 1B. This is why output matters, as if output rises in A but all other factors remain the same then prices in A will fall so A’s currency will get stronger.
There is not a strong relationship between the fundamentals of an economy and the exchange rate, at least in the short term. A key assumption of the monetary model, that the relative price level moves freely with the exchange rate does not appear to be the case, the relative price level can be sticky while the exchange rates are quite volatile.[Gregory P. Hopper, What determines the exchange rate: Economic factors or Market sentiment, Business Review, (sep./oct. 1997), p.19 http://www.philadelphiafed.org/research-and-data/publications/business-review/1997/september-october/brso97gh.pdf%5D%5D
It may well also be that it is news of the fundamentals that helps set exchange rates rather than the fundamentals themselves so you would expect greater volatility in the exchange rate to reflect the changing perceptions
What do you think?