Exchange rates indicate the rate at which one currency can be converted in another or in simpler terms they indicate how much a specific currency is worth in a foreign currency. Exchange rates play a vital role for governments and large financial institutions as well as for investors and forex traders.
There is a number of factors that can cause changes in currency prices and as a consequence affect currency exchange rates. Some of the most important ones are presented below.
Generally, countries with consistently lower inflation rates have a rising currency value with an increasing purchasing power compared to other currencies. In contrast, countries with higher inflation typically experience depreciation of their currency value.
Interest rates, inflation, and exchange rates are linked. Any manipulation of interest rates by central banks affects inflation and exchange rates. A country with higher interest rates offers lenders a higher return in relation to other countries, it attracts foreign capital, and thus the currency exchange rate increases. The analogous correlation exists for decreasing interest rates as they tend to cause exchange rates to decrease as well.
Current Account Deficits
A current account reflects the balance of trade among a country and its trading partners, and it includes transactions for exports, imports, and debt. A deficit in a country’s current account signifies that the cost of foreign trade is higher than the profits through sales exports and the country has to borrow to cover the deficit. As a consequence, the country’s exchange rate decreases.
Public debt is owned by the central government of a country and it is typically generated when the country engages in deficit financing to cover public expenses and governmental funding. Large public deficits render a country unattractive to investors which in turn translates to fewer chances of acquiring foreign capital. That causes higher inflation and a decrease in the exchange rate.
Terms of Trade
The terms of trade refer to a ratio that compares export prices to import prices. When the price of a country’s exports increases by a higher rate than that of its imports, it means that there is great demand for its exports and its terms of trades are improved. The increased revenues from exports increase the demand for the country’s currency and extend the currency value and its exchange rate rise. However, when the price of exports increases by a smaller rate than that of its imports, the currency value and its exchange rate decrease.
Economic Performance and Political Stability
Countries with strong economic performance and political stability become investment hubs as such positive financial conditions are highly likely to attract investors from countries that lack these key attributes. The rise in foreign capital results in currency appreciation and an increased currency exchange rate. However, countries displaying a high probability of political tensions are likely to experience a deprecation in the exchange rate of their currency.
Why study these factors?
Forex traders ought to comprehend the workings of the basic forces that affect exchange rates to be able to make informed decisions when placing trades in the forex market, the largest financial market with an average daily volume of $6.6 trillion (according to Triennial Central Bank Survey).
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