The forex market is essentially governed by the law of supply and demand and is generally not regulated by any government or coalition of governments. This is true in the U.S., where participation in the forex market is not regulated. The prices set for each country's money is determined by the desire of those trading to acquire more of it or to hold less of it. Each individual acts on the belief that he or she will benefit from the transaction.
According to the law of supply, as prices rise for a given item (in this case money), the quantity of the item that is supplied will increase; conversely, as the price falls, the quantity provided will fall. The law of demand states that as the price for an item rises, the quantity demanded will fall. As the price for an item falls, the quantity demanded will rise. It is the interaction of these basic forces that results in the movement of currency prices in the forex market.
How do changes in a currency's value affect a country's domestic economy? To show the effects, we can look at the U.S. economy during the 1990s. The dollar was quite strong in relation to other currencies during most of that period. Dollars were in high demand for a number of reasons. Among these was the desire of foreign citizens to buy U.S. financial securities such as Treasury notes and bonds, corporate bonds, and other U.S. assets. Part of the reason for this was the general attractiveness of U.S. government securities; another was because U.S. financial markets were booming through much of the period.
Factors Contributing to a Strong Currency
- Higher interest rates in home country than abroad
- Lower rates of inflation
- A domestic trade surplus relative to other countries
- A large, consistent government deficit crowding out domestic borrowing
- Political or military unrest in other countries
- A strong domestic financial market
- Strong domestic economy/weaker foreign economies
- No record of default on government debt
- Sound monetary policy aimed at price stability.
Factors Contributing to a Weak Currency
- Lower interest rates in home country than abroad
Higher rates of inflation
- A domestic trade deficit relative to other countries
- A consistent government surplus
- Relative political/military stability in other countries
- A collapsing domestic financial market
- Weak domestic economy/stronger foreign economies
- Frequent or recent default on government debt
- Monetary policy that frequently changes objectives.
Many sectors of the U.S. economy were borrowing heavily during this period. Government, corporations, and individuals were relying on credit. This created strong demand for money to lend to borrowers. Typically, money saved by consumers is used to help meet such demand. Unfortunately, savings rates in the U.S. were low. Consequently, the money for U.S. borrowing had to come from somewhere. Funds from abroad helped to meet the demand. This rise in demand increased the price of dollars relative to other currencies. This, in turn, made it more attractive for investors to hold dollars.
At the same time, the Federal Reserve kept inflation under control. This made the dollar attractive because of its stability. These trends combined to raise the cost of the dollar for foreign investors. The relatively high rates of return in U.S. financial markets enabled investors to earn better profits than could be found in their own financial markets. The increased demand for U.S. investments helped to make the dollar stronger. In addition to attractive rates, foreigners were eager to invest in the United States because this country was, and still is, seen as a comparatively stable, safe haven where investments are secure.