7 Factors That Influence Exchange Rates

factors that influence exchange rates

Understanding the factors that influence currency exchange rates is crucial for both countries and individuals. For nations, these elements impact international trade dynamics, while for individuals, they determine the amount received when converting currencies.

Although these factors can be complex and challenging to predict, knowing them is beneficial, especially if you are involved in foreign currency transactions. It’s essential to note that these factors influence exchange rates on a macroeconomic scale, affecting global currency rates rather than just local ones.

What Controls the Exchange Rate?

Exchange rates can feel like a rollercoaster ride – exciting at times and unsettling at others. However, they’re more than just figures on a screen or in the news; think of them as prices. Some, like your favourite coffee shop’s latte, remain steady, while others, like the weather, are unpredictable.

There are two primary types of exchange rates: fixed and floating.

In the past, fixed exchange rates were based on gold and silver. Nowadays, we have a managed floating exchange rate system. The actions of governments and banks shape floating exchange rates.

Factors That Influence Exchange Rates

In this article, we delve into the factors influencing currency exchange rates, beginning with the most significant of Inflation.

1. Inflation

Inflation refers to the relative purchasing power of a currency when compared to other currencies. For instance, if it costs one unit of currency to buy an apple in one country but a thousand units of a different currency to buy the same apple in a country with higher inflation, this disparity highlights the differing purchasing powers of these currencies.

Such differences in inflation levels are fundamental to why currencies vary in their exchange rates. Generally, countries with low inflation tend to have stronger currencies than those with higher inflation rates.

2. Interest Rates

Interest rates are closely linked to both inflation and exchange rates. Central banks in different countries use interest rates to manage domestic inflation. For instance, higher interest rates tend to attract foreign investment, strengthening the local currency.

However, if interest rates remain elevated for an extended period, inflation may rise, leading to a devaluation of the currency. Therefore, central bankers must continually adjust interest rates to maintain a balance between these benefits and potential drawbacks.

This is among the most powerful factors affecting currency exchange rates.

3. Public Debt

Countries often resort to large-scale deficit financing to fund public sector projects and government initiatives. While this can stimulate the domestic economy, nations with substantial public deficits and debts become less appealing to foreign investors.

The reason is that large debts tend to drive inflation, meaning that future debt payments will be made with cheaper real dollars.

In the worst-case scenario, a government might print money to cover a large debt, which increases the money supply and inevitably leads to inflation.

If a government cannot manage its deficit through domestic means, such as selling domestic bonds or increasing the money supply, it will have to offer more securities to foreign investors, thereby lowering their prices.

Additionally, large debts can be concerning to foreign investors if they believe there is a risk of default. This concern makes foreign investors less willing to hold securities denominated in the country’s currency.

factors affecting currency exchange rates

4. Political Stability

A politically stable country tends to attract more foreign investment, which supports a stronger currency rate. Conversely, poor political stability can devalue a country’s currency. Political stability also impacts local economic drivers and financial policies, which can have long-term effects on a currency’s exchange rate.

As a result, countries with strong political stability, like Switzerland, typically have stronger and higher-valued currencies.

5. Economic Health

The economic health or performance of a country significantly influences exchange rates. For instance, low unemployment rates indicate that citizens have more disposable income, contributing to a stronger economy.

A robust economy attracts more foreign investment, which helps reduce inflation and increase the country’s currency exchange rate. It’s important to note that economic health is a broad term that includes various factors such as interest rates, inflation, and the balance of trade.

This decided the future of the GDP of a country among the factors affecting currency exchange rates.

6. Balance of Trade

The balance of trade, or terms of trade, refers to the difference between a country’s imports and exports. A positive balance of trade means that a country exports more than it imports, resulting in a higher inflow of foreign currency compared to the outflow.

This increase in foreign exchange reserves enables the country to lower interest rates, stimulating economic growth and strengthening the local currency exchange rate.

7. Current Account Deficit

The current account deficit is closely tied to the balance of trade, comparing a country’s balance with those of its trading partners. When a country has a higher current account deficit than a trading partner, its currency tends to weaken relative to the partner’s currency.

Therefore, countries with positive or low current account deficits typically have stronger currencies than those with high deficits.

How Do Exchange Rates Affect The Economy?

Well, well, well, it seems our “exchange rate” is back at it, influencing the real economy like it runs the show. But let’s be honest, the most direct impact it has is on the demand for exports and imports.

When the domestic currency depreciates, exports become more attractive to foreign buyers because they’re cheaper (nice move, currency). However, it also makes imports more expensive, making us feel like broke college students trying to buy top-shelf liquor at the bar.

Domestic goods suddenly become hot commodities, providing a much-needed boost to our economy. These determinants of exchange rates have a severe impact on the economy.

What Happens When Exchange Rates Increase?

It’s like getting a raise and finding that everything just became a bit cheaper. Trading with other countries has suddenly become a lot more enticing.

Now, you can afford to buy more fancy French cheese for the same amount you used to spend on domestic cheddar (sacre bleu!). And let’s not forget the potential for cheaper vacations abroad. Those overpriced cocktails on the beach suddenly don’t seem so overpriced anymore.

Of course, the flip side is that our exports become less appealing to foreign buyers, making it a bit of a double-edged sword.

Bottom Line

The exchange rate of the currency in which a portfolio holds most of its investments plays a crucial role in determining the portfolio’s real return. A falling exchange rate reduces the purchasing power of income and capital gains from any returns.

Additionally, the exchange rate affects other income factors such as interest rates, inflation, and even capital gains from domestic securities. So, understand these determinants of exchange rates to trade safely in the currency markets.

Leave a Comment

Your email address will not be published. Required fields are marked *