Who sets exchange rates?

I am interested in where the data of supply and demand is taken from to calculate any given exchange rate, and who actually uses that data to calculate the official exchange rate?

The market decides the exchange rate, no calculations are necessary, it is just the point at which sellers and buyers are prepared to do business. There are many factors that economic theory suggests determine this level. Just think of things that would cause demand or supply for a currency to increase or decrease. For instance, if interest rates are expected to rise in the future then this will increase demand for a currency as it will yield a greater return for those who hold that currency, so theory predicts that the value of this currency will rise. Read up on macroeconomics, international economics and basic supply and demand if you're interested. It won't hurt in knowing (probably) but most people in this forum are chartists and only give minor consideration to fundamentals.

So your saying that its only the buyers and sellers in the fx market who determine the exchange rate of a currency? Because there is obviously a lot of money outside the fx market changing hands at any point in time. A good example is the amount of money being printed by the fed. Thats increasing supply exproportionately and is completely outside the fx market. Of course you can expect such a fundamental to work its way into the fx market through the short selling of investors trying to capture profit, but even with that pressure, its hard to tell how accurate that is reflecting the real supply of the currency. Even perceived demand on the fx market could be different to the demand outside the interbank market, through something like tourism, where the exchange rate is set off the fx market, but there could be a great deal of variance in demand amoungst those holidaying compared to those conducting business and speculating on the fx. All the same I wouldnt be surprised if u were right, im just somewhat surprised, since I thought purchasing power parity always needed to be acheived through change around in exchange rates. If the exchange rate is so open to interpretation, it makes that a very inaccurate science.

Well, yes, this is true of any market really.

But you have to account for who are the buyers & sellers in the Forex market. Realize that in some cases (like JPY) these "buyers & sellers" are actually the country's central bank, artificially propping up the currency. They are "buyers & sellers" but are playing an active, modifying role in the otherwise free & open market.

I understand what you're saying, the markets are the same, if they diverged it would be quickly exploited as it would present an arbitrage opportunity, which can only ever exist in the short term. The market rate is determined by supply and demand so a large proportion is dictated by day to day transactions and flows of money unrelated to speculation but in the same way that arbs can only exist in the short run, any discrepancies between the exchange rate and the expectation of future value will be filled by profit seeking speculators. Also, the exchange rate is not a function of this data, but rather it is a function of the aggregate interpretation of the likely future value of market participants, which is certainly effected by money supply, interest rates, inflation etc., but a market instrument will often lead a different life to the physical reality of a nation, stock, commodity etc., so attempting to derive a value from the economic components is flawed in my opinion. What I do believe is viable though, is to rank the strengths and weaknesses and match the strong hands with the weak. Even then, it would be foolish to not back it up with some sort of technical analysis.

LongToBeFree

"Realize that in some cases (like JPY) these "buyers & sellers" are actually the country's central bank, artificially propping up the currency."

I see, thats most interesting. I know that some central banks do weaken their own currencies to allow exports to stimulate their economy also.

Iv been wondering indeed lately if the $'s resistance to the increase in money supply has been solely due to the effects of deleveraging, dollar denominated asset sell offs and the net result of many shorts on the usd liquidating. I understand there must be a lot of money being pumped back into dollars through these mediums, but still, I would have thought that those forced to liquidate would surely sell their dollars off as soon as possible. If thats true, the sell off should be quick and leave just the effects of deleveraging to support the dollar. The dollar is still strong though. In fact it has consistently risen since the housing crash despite the U.S. has not having suffered from any deflation, having a trade defecit and the price of oil being at long time lows.

Do you think there is a large degree of intervention from the fed in supporting the dollar here? If so, how dangerous do you think that would be for them, given the long term fundamentals of the dollar? Do you happen to know of any examples in which the U.S. has supported the dollar directly in the fx or any market, and if so was it successful? Thanks for thoughts, MjrB.

"Birdt"

Thanks for the answer. You say,

"any discrepancies between the exchange rate and the expectation of future value will be filled by profit seeking speculators."
"a market instrument will often lead a different life to the physical reality of a nation, stock, commodity etc."
"attempting to derive a value from the economic components is flawed in my opinion."

I agree Birdt that economic data is priced in before releases. Data releases and forecasts are both more than likely flawed also because of the difficulty in producing accurate data and sometimes political motives at large.

Do you think however that fundamentals can tell you things about long term moves, and where to put your money with that respect? My observation is that although the data is not reliable when isolated over one or a few results, you can get a decent idea of the big picture, and with that you can see the long trends forming with respect to the business cycle and overall growth of the economy. Paying attention to credit overexpanding against income for example were strong signs prior to the housing market and dot com crashes that trouble was on its way, yet many people continued to invest in these assets believing that demand couldnt run out. Thanks for answers, MjrB.

http://www.ny.frb.org/education/addpub/usfxm/

read about efficient market hypothesis. It says that if you are speculating in the market, you are pretty much trying to predict the future. Many people disagree with this, but it is still pretty popular.