Short-Run and Long-Run Exchange Rate Determinants

1. The Core Engine: Supply and Demand

Before we can analyze what shifts exchange rates, we must first be clear on the basics of supply and demand in the foreign exchange (forex) market. In any currency pair, say USD/CAD, there are two sides to the market.

Let's watch a short video that clarifies who is demanding and who is supplying each currency. This is a foundational concept for everything that follows.

As the video explains, the key takeaway is:

• Demand for a currency comes from foreigners who want to buy that country's goods, services, or financial assets. (e.g., Canadians demand USD).
• Supply of a currency comes from domestic residents who need foreign currency to buy foreign goods, services, or financial assets. (e.g., Americans supply USD).

Any determinant of exchange rates works by influencing either this demand or this supply.

2. Short-Run Determinants: The Flow of Capital

In the short run (days, weeks, months), the overwhelming driver of exchange rates is the movement of financial capital seeking the highest short-term returns. Investors will move billions of dollars across borders to capture even small advantages in interest rates.

The key short-run determinants are:

• Interest Rate Differentials: This is the most significant driver.
• Market Expectations and Sentiment: News, political events, and investor mood can cause rapid shifts.

Let's see a practical example of how interest rate differentials impact the market.

To summarize the video's crucial example:

1. Event: Interest rates in the U.S. (15%) become much higher than in Canada (2%).
2. Investor Action: Canadian investors want to earn the higher U.S. interest rate. To do so, they must sell their Canadian dollars (CAD) and buy U.S. dollars (USD) to invest in U.S. bonds.
3. Market Impact:
   • The demand for USD increases (shifts to the right), causing the USD to appreciate.
   • The supply of CAD increases (shifts to the right), causing the CAD to depreciate.

This relationship is formalized by a theory called Uncovered Interest Rate Parity (UIRP). While a detailed mathematical treatment is beyond the scope here, its core idea is essential.

You might notice a seeming contradiction: the video shows the high-interest-rate currency appreciating, while the UIRP theory says it should depreciate. Here is how to reconcile this for the exam:

• Short Run (Flow Effect): The immediate flow of capital into the high-interest-rate country causes its currency to appreciate. This is the effect shown in the Jacob Clifford video and is the dominant short-run driver.
• Long Run (Expectation Effect): UIRP suggests that over the long term, this appreciation must be reversed. The currency is expected to depreciate in the future to ensure that, on average, returns are equalized across countries.

For the CFA exam, when asked about short-run determinants, think of capital flows driving the high-interest-rate currency up.

3. Long-Run Determinants: The Flow of Goods and Services

Over the long run (years, decades), the temporary effects of capital flows fade, and the exchange rate is anchored by the trade of actual goods and services.

A. Purchasing Power Parity (PPP)

The most important long-run theory is Purchasing Power Parity (PPP). It states that the exchange rate between two countries should adjust so that an identical basket of goods costs the same in both countries.

The most practical version is Relative PPP, which focuses on inflation. It posits that the change in the exchange rate should be approximately equal to the inflation differential between two countries.

% Change in Exchange Rate ≈ Foreign Inflation Rate – Domestic Inflation Rate

If a country has persistently higher inflation, its currency must depreciate over the long run to keep its goods competitive.

B. Balance of Payments Approach

This approach states that a country's trade balance has a long-run effect on its currency. A country that consistently runs a trade surplus (exports > imports) will see a persistent demand for its currency, leading to long-run appreciation. Conversely, a country with a chronic trade deficit (imports > exports) is constantly supplying its currency to pay for foreign goods, leading to long-run depreciation.

These trade and capital flows are linked through a fundamental macroeconomic identity:

Where:

• $X-M$ = Trade Balance (Exports - Imports)
• $S-I$ = Private Sector Balance (Private Savings - Investment)
• $T-G$ = Government Balance (Taxes - Government Spending)

This equation shows that a trade deficit must be financed by an inflow of capital (e.g., private investment exceeding savings, or a government budget deficit).

4. Synthesis: Putting It All Together

Let's revisit our initial diagram.

• The long-run equilibrium path is determined by PPP (inflation differentials) and trade balances. This is the fundamental anchor for the currency's value.
• The short-run path is driven by capital flows. When a central bank raises interest rates, capital floods in, causing the currency to appreciate sharply, often "overshooting" its long-run equilibrium value.
• The medium-run path is influenced by the business cycle. A country in a strong economic expansion may attract investment (strengthening the currency) but also increase its imports (weakening the currency). The net effect depends on the relative strength of these factors.

Conclusion

In this lesson, we have dissected the complex forces that drive exchange rates. By separating the determinants into short-run and long-run factors, you can build a coherent framework for analyzing currency movements.

Key Takeaways:

• Exchange rates are fundamentally determined by the supply and demand for currencies.
• In the short run, the market is dominated by capital flows. The key determinant is interest rate differentials, with higher rates attracting capital and causing short-term appreciation. News and market sentiment also play a major role.
• In the long run, the exchange rate is anchored by the flow of goods and services. The key determinants are inflation differentials (Relative PPP) and persistent trade balances. A country with higher inflation or a chronic trade deficit will likely see its currency depreciate over time.
• The actual path of an exchange rate is a volatile short-run journey around a more stable long-run trend.

Preview of the Next Lesson:

We have now established what exchange rates are, the regimes they operate under, and what causes them to move. The final piece of the puzzle is to understand the consequences of these movements. In our next and final lesson of this module, we will explore the question: What is the impact of exchange rate movements on international trade and capital flows?