6 Factors that Affect Currency Exchange Rates
Exchange rates and what they mean
Isn’t this the most common conversion we all have seen?
This conversion basically tells us that the worth of 1 U.S Dollar is equivalent to 74 Indian Rupees.
But where did this conversion come from? How do we arrive at this?
Read on to find out.
Well firstly, we see the U.S Dollar, the euro and the yen most often because they are among the strongest currencies. These currencies are the ones most widely used around the globe for the purpose of international trade and transactions. The U.S dollar is considered the standard currency for the trade of a lot of commodities internationally.
The exchange rates are also of significance for foreign exchange trading. The foreign exchange trading, also known as forex trading, is the trading of currencies. An example of how it works is that one can swap rupees for euro or vice versa.
The forex market is the largest, most liquid market present. It has trillions of dollar worth of transactions happening every day. It has no location and is an electronic network consisting of many entities that are involved or required in the transactions that are placed in the foreign exchange market.
Exchange rates are always listed in pairs. For example, USD/INR represents the U.S dollar vs Indian rupees.
These pairs also have a price associated with it.
For the sake of an example let’s say the price is 1.5 and the pair is ABC/XYZ.
This means that it costs 1.5 XYZ to buy one ABC.
Now let’s talk about the factors that affect these rates and what determines these values that we see.
Inflation is the rise in price level of an economy over a certain period of time. Inflation is said to have an inverse relation with the strength of the currency. The lesser the inflation, the stronger the currency. Increased inflation is caused because of increase in prices of goods, with no or relatively lower increase in the purchasing power, among many other reasons.
While interest rates is considered a factor of its own, it is highly correlated to inflation. Countries’ central banks use interest rates to control the inflation in a country. The higher the interest rates, the more it attracts foreign investors, which further bolsters its currency rates.
But if inflation also stays high for too long, the high interest rates can’t hold the currency. And it ultimately leads to currency devaluation.
Current account deficit
What this simply means is that there is a deficit in the current account of the country or it is spending more money on foreign trade than it is earning. This is generally accompanied with borrowing capital from foreign entities to fill up the deficit.
The increased demand for foreign goods (or currency) reduces the exchange rate.
Public debt again is correlated to inflation. Here’s how. Public debt is the borrowing of the government to fulfill projects or other related functions. The more the debt, higher the chance of inflation. Countries with large public deficits or debts are not as attractive to foreign investors. This is because the inflation results in a threat to the returns of foreign investors since the exchange rate weakens with increasing inflation.
Political stability and economic performance
This one is more intuitive. Political stability and economic performance is reviewed by investors before investing in a country. Naturally, the better these factors, the more attractive a country becomes in terms of foreign investing. These factors can either cause a gain or loss in confidence of foreign investors towards investments in a country.
Traders also study the expected change of the strength of currencies before trading in it. The demand of a country’s currency increases if the value of it is expected to go up. This enables investors to make a profit in the future. Due to this speculation of an increase in value of the currency, the demand for it increases. This results in increasing the exchange rate as well.
These are some of the important and prominent factors that affect the exchange rate of a country.
- Exchange rates is a rough indicator to the overall economic strength of the country.
- The strongest currencies of the world are taken to be the standard currency for international trade.
- A high interest rate can increase the currency value in the short term, but it may not sustain due to a high inflation environment.
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