How global exchange rates are determined

[teodorakis]

Hi,
I would like to ask about how the exchange rates are determined. I understood the concept of supply and demand, but my question is more technical than conceptual, i mean where is the information of the rates are coming from? Is there any center that keeps the track of, for example every single dollar in the world or any other currency? I hope i can explain myself, i know my question is ridicilious but i can't seem to find it on the net and can't find a palce to ask:)

 

[Solcielo L]

I thought currency was traded on the global market so that's how exchange rates are set. It doesn't make sense to me that you'd trade money to make money.

 

[pbuk]

The information comes from traders who publish the rates at which they are willing to buy and sell currency. There is no reporting of actual currency trades (unlike for example quoted shares) or any other centralised tracking of currency movements in general.

 

[phyzguy]

Exchange rates are set the same way as the price of any commodity is determined, i.e. by the marketplace. How is the price of corn, wheat, or oil determined? By what people are willing to pay for it. People are constantly buying and selling dollars in exchange for euros, yen in exchange for dollars, etc. This constant stream of trades is what sets the exchange rates.

 

[AlephZero]

People are constantly buying and selling dollars in exchange for euros, yen in exchange for dollars, etc. This constant stream of trades is what sets the exchange rates.

And in practice, if there are N currencies, there are only N independent "exchange rates", not N-squared rates between every separate pair of currencies, because if you could make "dollars from nothing" by simultaneously buying (for example) yen with dollars, pounds with yen, and dollars with pounds, somebody would do that until the rates moved into line with each other.

There was a nice story from the Gorbachev era in the USSR, when they were trying to understand western capitalism. They sent an official delegation to the UK to learn how things worked. One of the first questions they asked was, "who is responsible for setting the price of bread in London?". They had a hard time getting their heads around the answers "nobody", or "everybody".

 

[wigglywoogly]

One of the first questions they asked was, "who is responsible for setting the price of bread in London?". They had a hard time getting their heads around the answers "nobody", or "everybody".

Unless there exists a degree of monopoly power in the market for bread, in which case you can say 'that group of people over there is mostly responsible for setting the price of bread'

Off topic, I know.

 

[Romulo Binuya]

Being aware of the forces that affects the global exchange rate is important especially if you are working in the c-suite and hence responsible for all the employees down the line i.e. their employment. http://www.investopedia.com/ask/answers/forex/how-forex-exchange-rates-set.asp

Thousands of miles away Thailand defended their currency the Baht which subsequently triggered international currency crunch.. and I lost my employment when our company went belly-up as a consequence. http://en.wikipedia.org/wiki/1997_Asian_financial_crisis

Our company didn't survived the crisis not due to lack of knowledge of what's going but due to error in judgement. http://intl.econ.cuhk.edu.hk/exchange_rate_regime/index.php?cid=2

 

[Naranja]

Hi,
I would like to ask about how the exchange rates are determined. I understood the concept of supply and demand, but my question is more technical than conceptual, i mean where is the information of the rates are coming from? Is there any center that keeps the track of, for example every single dollar in the world or any other currency? I hope i can explain myself, i know my question is ridicilious but i can't seem to find it on the net and can't find a palce to ask:)

Rates are quoted on the FOREX (foreign exchange market). They are quoted in currency pairs like the US Dollar vs Japanese Yen. You can get these quotes live from a broker when you have an account: http://www.forexdirectory.net/quotesfx.html

They are quoted as bid/ask. Bid is the price that the market maker will buy from you (what you can sell at), and Ask is the price that the market maker will sell to you (what you can buy at).

Sometimes, from other sources, you'll see the US Dollar quoted against a basket of currencies: https://research.stlouisfed.org/fred2/series/DTWEXM http://stockcharts.com/h-sc/ui?s=$USD

As to your question about who tracks every single dollar, that would be the central bank, US Federal Reserve. Money and currency are not the same thing. Currency is the actual physical cash that is in circulation in public. Most currency is overseas. Some countries like Panama use the US Dollar as their national currency, but most of it is used for the drug trade throughout the world. US currency that is outside of the US is called Eurodollars. So, it is impossible to know for sure how much physical currency is out there since it sometimes gets destroyed.

There are different ways of calculating money because of the traditional banking system and shadow banking system. The kinds of digital money that exists in commercial banking are non-bank deposits (customers' deposits in checking and savings accounts) and bank reserves for loan to reserve ratios per Federal regulations.

The shadow banking system (shadow because it is loosely regulated unlike commercial banks) includes credit card credit, home loan credit, money market accounts, student loans, etc.

The Federal Reserve controls the money in an economy by increasing and reducing the amount of base money, which controls the economy. The Monetary Base includes currency in circulation and banks' reserves. By selling or buying bonds from commercial-dealers (banks), they can control the amount of money the banks have in reserves. Larger reserves gives the banks more money to loan out. More money loaned is spent by borrowers. 70% of the US economy (GDP) is from domestic spending. https://research.stlouisfed.org/fred2/series/BASE

The direction of exchange rates are usually determined by the benchmark interest rate set by a country's central bank. When the benchmark rate is lowered, signalling an economic slowdown that the central bank is fighting, that country's currency will go down in value in relation to other countries. The US Federal Reserve sets the Federal Funds rate, which is an overnight rate that banks use to lend to one another. https://research.stlouisfed.org/fred2/series/FEDFUNDS

The lower domestic interest rate will make domestic goods and services look cheaper than foreign goods and services. Vice versa, our goods will look cheaper to foreigners, and their own own goods will look more expensive to them. That should reduce imports and increase exports for us. However, not all economies are the same.

Some economies like China and Japan do not have a strong middle class like we do. China is developing, and Japan has a small population in relation to what it produces (the size of their GDP) so they are export economies. It is in their best interest to lower their own foreign exchange rates in order to export goods. The US is a domestic economy. We have a strong middle class with 70% of GDP coming from domestic spending (consumption); 10% from trade. I forget government spending and business spending, but business spending is more than government spending.

Export economies can manipulate foreign exchange rates. It is sometimes called beggar-thy-neighbor. A central bank can print money in its own currency, then go to the FOREX, and buy US Dollars. That will make their currency decrease in value in relation to the US Dollar providing their own country with jobs stolen from the US through increased exports to us. The consequence of currency manipulation will be instability in inflation in their economy.

Another problem these countries will have is where to park all of those US Dollars. They can't be spent in their countries because they use a different currency. If they tried to buy US real estate that would probably start a riot or a war. So, they buy US Treasury bonds. You can see a list of the currency manipulators here: http://www.treasury.gov/ticdata/Publish/mfh.txt China and Japan have over 1.2 trillion dollars in Treasury bonds each.

We don't need them to buy our bonds. We have plenty of domestic buyers. They are manipulating currency to increase their exports and steal jobs.

In a global recession, every country is lowering its benchmark interest rate, so it is a race to the bottom as far as exchange rates are concerned. Right now, the only currency that has not fallen or tried to fall in relation to others is the euro. Euro countries like France and Spain have massive unemployment as a consequence. https://research.stlouisfed.org/fred2/series/ESPURHARMQDSMEI

This is how, I believe, global foreign exchange rates are set.