What Determines the Exchange Rate of the Korean Won?

The determination of exchange rates in international financial markets is, of course, based on the supply and demand between foreign exchange and the local currency. The supply of foreign exchange is determined by the current and capital account balances. In the world before the 1990s, when the capital market was not liberalized, the current account determined the supply of foreign exchange. As the share of income transfer between countries remained relatively low, the current account balance was actually determined by the trade balance.<br><br>The Korean foreign exchange market is traded on a dollar basis, so the supply and demand of the dollar determines the Korean won’s exchange rate. In South Korea’s foreign exchange market, it is U.S. monetary policy that most directly affects the supply and demand of the dollar. U.S. monetary policy is more influential than Korea’s in determining the won’s exchange rate. This phenomenon is hardly limited to the Korean currency market.<br><br>The index that works most closely with the Korean won’s exchange rate is the U.S. dollar index. The dollar index is an indicator of the international value of the U.S. dollar. The most important factor that determines the dollar index is U.S. monetary policy. Therefore, in order to predict any changes in the Korean won’s exchange rate, one must first look at the variables affecting the dollar index. Those looking to understand changes in Korea’s exchange rate should pay particular attention to changes in U.S. monetary policy.