In a free market the rate of exchange is determined by the market forces of supply and demand. Where these conditions apply the exchange rate is said to free, fluctuating or floating. Therefore the following have a great impact on the rate of exchange in a free market:
An increase in the demand for the $NZ will result from more people wanting get or buy $NZ.
* Increase in the value of exports
* Increase in tourists travelling to NZ
* Increase in foreign investment in NZ (buying assets / companies / depositing savings)
* Increase in NZer’s taking out loans overseas
An increase in the supply for the $NZ will result from more people wanting get or buy other currencies (as they have to supply $NZ to the market to get the other currencies)
* Increase in the value of imports
* Increase in NZer’s travelling to other countries
* Increase in NZ investment overseas
* Increase in NZer’s repaying loans made overseas
For these purposes NZ residents must obtain foreign currencies. Banks, acting on their behalf, will buy these currencies in the foreign exchange market and pay for them with dollars. Thus, an increase in NZ imports will increase the supply of dollars in the foreign exchange market. With floating exchange rates, changes in market demand and market supply of a currency cause a change in value.
An example using the US$ and Euro
French citizens want to buy goods from the USA and supply euros (Graph A) to their banks and demand dollars (Graph B) to import goods and services from the United States. The value of the euro falls from $1.00 to $0.98. Simultaneously, the value of the dollar appreciates from 1.00 to 1.02 euros.
If U.S. citizens want to buy goods from France they must supply dollars to their banks (Graph C) to demand euros to import goods and services from France (Graph D). The value of the dollar falls from 1.02 euros to 1.00 euro.