What Determines Exchange Rates:
Short Run Exchange Rates are Determined by Supply and Demand:
What Determines the Demand for a Currency?:
- Demand for goods, services and investments priced in that currency. If I want to buy Canadian bonds or Canadian maple syrup, then I will need Canadian dollars to do so. If total expenditures, by non-Canadians, on these items rise, the demand for the Canadian dollar will rise.
- Speculators. If I believe, for whatever reason, the Canadian dollar will rise in value in the future, I will want to buy more Canadian dollars today.
- Central banks - Occasionally central banks will buy up a foreign currency to affect the exchange rate.
What Determines the Supply of a Currency?:
- Demand for goods, services and investments priced in a different currency. If I want Canadian maple syrup, I will need Canadian dollars. To get Canadian dollars, I will have to supply a currency in return, such as yen or U.S. dollars.
- Speculators. If I believe, for whatever reason, the Canadian dollar will fall in value in the future, I will start to sell off my Canadian dollars today (that is, supply them to the market).
- Central banks through increases in the money supply. See: Why Not Just Print More Money?
What Should The Currency Be Worth?:
It turns out there is at least a rough level to which a currency should be worth - please see A Beginner's Guide to Purchasing Power Parity Theory. The exchange rate, in the long run, needs to be at the level which a basket of goods costs the same in two currencies. Thus if a Mickey Mantle rookie card costs $50,000 Canadian and $25,000 US, the exchange rate should be 2 CDN = 1 US.