5 Key Factors Affecting Exchange Rates

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5 Key Factors Affecting Exchange Rates

When trying to keep up to date with all the news on the internet and on the TV, it is easy to get caught up with the magnitude or information and its variety. However not all of it is vital or necessary for trading forex. Here, we take a look at the more important ones that you should keep your eyes open for. Before we begin, remember that currencies are relative to each other and hence news or information should be seen as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate of the currencies.

  1. Interest rates

When comparing the differentials between interest rates of countries, we have to remember that interest rates, inflation and exchange rates are all highly correlated. Hence by manipulating the interest rates, central banks are able to have some influence over both inflation and exchange rates. To put it simply, the country with higher interest rates offer lenders in the economy a higher return relative to other countries. As such they would attract more foreign capital and this demand for their currency will thereby cause the exchange rate to rise. The impact of the currency is mitigated if the inflation rate of that country is much higher than the other since the inflation will drive the currency down

  1. Inflation rates

When a country with low inflation rate exhibits a rising currency value, their purchasing power increases relative to other currencies. Based on historical information we are able to typically see that countries with higher inflation are usually faced with depreciation in their currency. This is usually accompanied by higher interest rates as well.

  1. Current account deficits

The current account is the balance of trade between a country and its trading partners. This includes payments of all kinds such as goods, services and interest. A deficit in the current account show the country is spending more on foreign trade than it is earning, and is borrowing foreign capital in order to make up for its deficit. This means that the country actually requires more foreign currency that it is able to receive through the sale of its exports. This also means that the country is supplying more of its own currency than is demanded by foreigners for its products. This excess demand for the foreign currency lowers the countries exchange rate until the domestic goods and services are cheap enough for foreigners to generate sales for the domestic market.

  1. Public debt

Some countries engage in large scale deficit financing in order to pay for public sector projects. Although this kind of activity is able to stimulate the domestic economy, nations with huge public deficits and debts are typically less attractive to foreign investors.

This is due to the fact that large debt often encourages inflation since inflation will allow the debt to be serviced and paid with cheaper real dollars in the future.

In certain cases, the governments even print money in order to pay off this debt. This increases the money supply in the market and hence inflation.  The impact in terms of inflation often will result in depreciation of the currency in the long run.

  1. Political stability and Economic Strength

This kind of information often affects foreign investors as they will be searching for stable countries with strong economic performance to invest their capital in. A country that has such attributes will draw investment away from other countries that are perceived to be more risky. As demand for their currency increases relative to the other countries, their currency will inevitably face inflation.