Looking to get familiar with factors that influence exchange rates of a currency? There is no doubt that a country’s trading relationships are largely determined by its currency exchange rate. In simple terms, exchange rate refers to the value of a currency in relation to another country’s currency or cluster of currencies.
Exchange rates are subject to fluctuations based on supply and demand in the market. More importantly, currency exchange rates are a clear indicator of a nation’s economic strength and stability. This is why they are constantly monitored and analyzed by governments and economists all year round.
Stronger exchange rates are a boon for countries as they can bring down inflation by reducing the price of imported goods. If you are keen to know how exchange rates get impacted, you are in the right place. Without more ado, let’s look at top 8 factors that influence the value of currency exchange rates in the forex market.
1. Level of inflation
The level of inflation has a direct impact on a country’s currency exchange rate. In layman’s language, inflation can be defined as a gradual drop in the purchasing power of a particular currency. In typical scenarios, countries with high inflation have weaker currencies.
Rising inflation paves the way for higher interest rates and causes the domestic currency to depreciate. On the other hand, low levels of inflation leads to appreciation in the currency’s market value.
2. Rate of interest
It must be noted that interest rates and inflation are closely related. In fact, changes in the rate of interest can impact currency values at a global level. Central banks in different countries often manipulate interest rates from time to time to exert influence on currency values.
Increase in interest rates provides benefits to international investors and opens the door for foreign capital inflow which in turn leads to rise in currency exchange rates. Likewise, a decline in interest rates brings about a fall in exchange rates as well.
3. Public debt
It is a common practice for countries to borrow funds for the purpose of financing government budgets, public projects etc. While borrowed funds can work wonders for kickstarting the economy, things can worsen if the country is unable to pay back its debt on time.
The accumulation of large amounts of debt by the central government can become a barrier to foreign investments. Since huge public deficits encourage inflation, they can drive potential foreign investors away. The worst part is that too much government debt can cause currency exchange rates to plummet dramatically.
4. Economic performance
The economic performance of a country is another major determinant of exchange rates. Countries boasting high employment levels tend to have stronger economic health. Moreover, countries that regularly exhibit excellent economic performance attract massive foreign investments from illustrious investors around the world.
The incoming investment flows further support the economy and facilitate the appreciation of currency exchange rates. If the economy plunges into recession, its likelihood to attract foreign capital decreases substantially. In such a situation, currency exchange rates become prone to depreciation. Countries looking to improve their exchange rate should aim for a booming economy.
5. Political stability
It goes without saying that the political environment of a country plays a pivotal role in influencing exchange rates. Affluent investors are less likely to make investments in countries affected by political turmoil. In fact, they would be more willing to invest in politically stable countries where there is scope for profit.
Lack of political stability can devalue the domestic currency and bring economic growth to a halt. The implementation of favorable monetary policies is vital for a country’s economy to thrive. A sound financial policy not only benefits the economy but also works in favor of boosting the exchange rates.
6. Currency speculation
As surprising as it may sound, currency speculation can also affect exchange rates. When the value of a specific currency is projected to rise, its demand skyrockets among investors. With the hope of profiting from appreciated exchange rates, investors purchase and hold currencies for a period of time.
Consequently, the value of the currency increases with the sudden rise in demand. Nonetheless, changes in exchange rates which stem from currency speculation are usually erratic and short-lived.
7. Current account deficit
All the transactions that take place between a country and its trading partners are reflected in the current account. A current account deficit is brought about when a country’s spending on foreign trade exceeds its earnings from exports. High deficits weaken the domestic currency exchange rate and propel countries to borrow capital from outside.
8. Terms of trade
Closely tied to the current account, terms of trade (TOT) can be described as the relative differential between the exports and imports of a country. When exports increase at a faster pace than imports, the inflow of foreign currency also goes up.
The revenue resulting from rising exports leads to an increase in the currency’s demand and value simultaneously. A positive TOT facilitates the growth of foreign exchange reserves and bolsters the economy. This strengthens the currency exchange rate to a great extent.
It is a known fact that a country’s level of trade is dependent on exchange rates. The imports of a country are cheaper when the domestic currency is strong and this can be beneficial to consumers. Conversely, a weaker currency causes imports to become costlier while lowering the price of exports in foreign markets.
Above all, a decline in currency value can negatively impact economic growth rates, thereby hampering a country’s progress significantly. Countries that are politically stable usually have good exchange rates. Having become familiar with the factors, If you are planning to send money overseas, you should keep a close eye on currency exchange rates to capture the best deal.
Once your favorite rate goes live, you can use a forex platform like BookMyForex to lock-in the rate for up to 3 days maximum.