The US economy is the largest globally, with a GDP of nearly $17 trillion, and it has a profound impact on currency movements around the globe. While the health of most developed economies can be measured with relative accuracy by looking at various economic indicators, things become more complicated when looking at developing countries due to their statistical opacity.
Over-reliance on a single indicator is dangerous, but given that most investors will trade according to how they perceive the health of the US economy, it makes sense to start there.
Changes in money supply
The money supply in any country with “fiat” currency [the US] is determined by its central bank [the Federal Reserve]. There are four primary money supply measures: M0, M1, M2, and M3.
M0 measures currency in circulation, while M1 includes all physical currency and demand deposits ( checking accounts). The other two measures, M2 and M3, include less liquid forms of money held by the public. Increases in the money supply generally lead to inflationary pressures; however, these can vary dramatically between countries due to their different policies.
Changes in commercial banks’ reserves with the Central bank
Reserve requirements refer to minimum reserves that banks must hold against transaction deposits or have stated as a percentage of total customer deposits. Central banks set these requirements, but it is commercial banks themselves who determine how much to hold. Banks with reserves over required levels are said to have “excess” reserves, while those below the requirement are deficient.
Changes in money multiplier
The money multiplier is a measure of how much a unit of currency, e.g. 1 dollar, can be expanded through credit creation and is calculated as:
M = C/R Where; M – Money Multiplier C – Currency held by The Public R – Reserve Requirement
Therefore, changes in variables determine how much the money supply expands with each unit of currency that enters into circulation. This number is determined by central bank policy and commercial bank behaviour, so it should come as no surprise that there are differences between countries.
Changes in interest rates
One of the primary tools that central banks use to control inflation and maintain financial stability is setting interest rates. If a central bank wants to expand credit, it will reduce the discount rate [i.e. making it cheaper for commercial banks to borrow from them].
However, if a central bank wants to contract credit, it will focus on increasing market rates through open market operations such as:
- repo auctions
- reverse repos and Fed Funds transactions
- direct intervention in the Forex markets
- or changing reserve requirements or discount rates
This link between interest rates and inflation is a crucial tenet of “monetarism”, which argues that changes in the money supply have a more significant impact on price levels than vice versa.
Changes in fiscal balance/government debt
The fiscal balance is a country’s revenue less its expenditures. A country with a deficit has more funds going out than in, while those with a surplus have opposite situations, i.e., running a trade surplus.
Government debt, meanwhile, is essentially borrowed money from investors and includes all forms of borrowing such as treasury bills, bonds, etc.
These indicators can be used to determine how much money a government or central bank will need to borrow from international lenders if it wants to finance budget deficits. The figure below shows US Govt. Debt/GDP [% of GDP] and its relation to interest rates.
Changes in foreign reserves
Countries’ central banks use foreign reserves to increase liquidity and guard against speculative attacks on their currencies. Central banks can work independently to accumulate these reserves, or they may be the product of fiscal policy, i.e. if a country runs a trade surplus, it will finance its accumulation of foreign reserves through its trade surplus.
However, in both cases, these reserves are invested abroad, meaning that changes can alter liquidity levels and capital flows between countries.
