The higher the domestic prices and production costs compared to foreign ones, the higher the import growth compared to export. Therefore, high domestic prices and low outside prices usually mean high foreign exchange prices. This factor, which was considered the most important in the 20th century, was called “purchasing power parity” of exchange rates. According to the concept of purchasing power parity, the change in the exchange rate ratio of the two countries, all other things being equal, is proportional to the change in the ratio between domestic and foreign prices.The stronger the desire to have foreign goods and use foreign services, the higher the price has to be offered for foreign currency. As national income grows, so does the demand for imported goods. This causes a tendency to cheapen the national currency. On the other hand, high national income abroad reduces the price of foreign currency. All this is due to the “propensity of the country to import”: an increase in national income leads to an increase in imports to almost the same extent as an increase in domestic consumption.
Moving capital
If investors want to get more foreign debt, bonds, stocks, bank deposits or cash, they add to the price of foreign currency. In contrast, payments from other countries to a certain country contribute to the strengthening of its national currency.This is the factor that determines the movement of capital, is closely related to currency speculation. If it was only an export of goods or payments for current transactions, the exchange rate of the foreign currency might have been sluggish and fluctuated very little. However, when the euro falls from 1.04 to 0.97 dollars per euro, many people start to fear that it will fall even more. That’s why they’re trying to get rid of the euro. The increase in sales of the single European currency and the reduction in demand for it as a result of short-term speculative movements in capital are contributing to a further decline in its exchange rate.Thus, small exchange rate fluctuations are often spontaneously exacerbated by the movement of “hot money,” which moves from one country to another in the face of any rumor of impending problems, a change in political direction, or exchange rate fluctuations. When such a “capital flight” begins on a large scale and in one direction, it can lead to sharp movements in exchange rates and even to a financial crisis.