Top 6 Factors Influencing Exchange Rates

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Top 6 Factors Influencing Exchange Rates

Aside from interest rates and inflation, one of the most significant drivers of a country’s relative degree of economic health is the currency exchange rate. Exchange rates are crucial to a country’s amount of commerce, which is critical to almost every free market economy on the planet. As a result, exchange rates are among the most closely monitored, examined, and manipulated economic metrics. However, exchange rates have an influence on the actual return of an investor’s portfolio on a lesser scale as well. In this section, we will look at some of the primary causes driving exchange rate changes.

Main Factors that Influence Exchange Rates

Overview of Exchange Rates

Before we examine these factors, we need consider how exchange rate swings impact a country’s commercial connections with other countries. A stronger currency makes a country’s imports cheaper and its exports more costly in international markets. In overseas markets, a lower-valued currency makes imports more costly and exports less expensive. A higher exchange rate is likely to worsen a country’s trade balance, whereas a lower exchange rate is likely to improve it.

Key Takeaways

  • Aside from interest rates and inflation, one of the most significant drivers of a country’s relative degree of economic health is the currency exchange rate.
  • A stronger currency makes a country’s imports cheaper and its exports more costly in international markets.
  • Exchange rates are relative and are represented as a comparison of two nations’ currencies.

Determinants of Exchange Rates

Exchange rates are determined by a variety of things. Many of these issues are connected to the two nations’ commercial relationship. Remember that exchange rates are relative and are stated as a comparison of two nations’ currencies. The following are some of the most important factors influencing the exchange rate between two nations. It should be noted that these components are not in any specific sequence; the relative relevance of these factors, like many other areas of economics, is hotly debated.

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Differentials in Inflation

A nation with a continually decreasing inflation rate often has an increasing currency value as its buying power grows in relation to other currencies. Japan, Germany, and Switzerland had low inflation in the latter part of the twentieth century, but the United States and Canada did not reach low inflation until much later. Countries with greater inflation often see their currency depreciate in relation to their trade partners’ currencies. Higher interest rates are frequently associated with this.

Differentials in Interest Rates

Interest rates, inflation, and currency exchange rates are all closely tied. Central banks control both inflation and exchange rates through regulating interest rates, and changes in interest rates affect both inflation and currency values. Larger interest rates provide lenders in an economy with a higher return in comparison to other nations. As a result, rising interest rates attract foreign money, causing the currency rate to increase. However, the effect of increased interest rates is offset if inflation in the nation is much greater than in others, or if other factors contribute to push the currency down. Lower interest rates tend to reduce exchange rates, whilst higher interest rates tend to increase exchange rates.

Current Account Deficits

The current account is the balance of commerce between a nation and its trading partners, representing all payments for goods, services, interest, and dividends between countries. A current account deficit indicates that the nation is spending more on foreign commerce than it is earning, and that it is borrowing cash from foreign sources to make up the difference. In other words, the nation needs more foreign currency than it obtains through export sales, and it provides more of its own currency than foreigners desire for its goods. Excess foreign currency demand lowers the country’s exchange rate until local products and services are affordable to foreigners and foreign assets are too costly to generate sales for domestic interests.

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Public Debt

Countries will engage in large-scale deficit financing in order to support public-sector initiatives and government spending. While such activity boosts the home economy, countries with huge public deficits and debts are less appealing to overseas investors. What’s the reason? A huge debt fosters inflation, and if inflation is strong, the loan will be serviced and eventually paid off in future cheaper real dollars.

In the worst-case situation, a government may create money to pay off a portion of a massive debt, but expanding the money supply always leads to inflation. Furthermore, if a government is unable to cover its deficit by selling domestic bonds and expanding the money supply, it must increase the quantity of securities for sale to foreigners, decreasing their values. Finally, a huge debt may worry foreign investors if they feel the government will fail on its commitments. If the risk of default is high, foreigners will be less eager to purchase assets denominated in that currency. As a result, the country’s debt rating (decided, for example, by Moody’s or Standard & Poor’s) is a critical predictor of its exchange rate.

Terms of Trade

The terms of trade are connected to current accounts and the balance of payments because they compare export prices to import prices. If the price of a country’s exports grows faster than the price of its imports, its trade conditions have improved. Increasing trade terms indicate increased demand for the country’s exports. This, in turn, leads to a rise in export income, which increases demand for the country’s currency (and hence its value). If the price of exports grows faster than the price of imports, the currency’s value falls in reference to its trade partners.

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Strong Economic Performance

Foreign investors will always seek for stable nations with excellent economic performance to invest in. A nation with such strong characteristics will attract investment dollars away from other countries thought to be more politically and economically risky. Political unrest, for example, may lead to a loss of faith in a currency and a flight of capital to more stable currencies.

The Bottom Line

The actual return of a portfolio is determined by the exchange rate of the currency in which the majority of its assets are held. A falling exchange rate reduces the buying power of income and capital gains from any returns. Furthermore, the exchange rate has an impact on other income determinants such as interest rates, inflation, and even capital gains from local assets. While exchange rates are governed by a number of complicated variables that often confound even the most expert economists, investors should have some awareness of how currency values and exchange rates affect the rate of return on their assets.

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