What Are Exchange Rates Influenced by?

by Andrew McGuinness     Jul 16, 2019

Exchange rates are basically the deciding factor that determines the value of a country’s currency in relation to all other countries in the world. Exchange rates also play a part in the importation and exportation of goods and services a country provides and receives. Investors will be particularly interested in the keeping track of exchange rates due to the fact this will affect the returns to be made from their forex trade portfolios.

There are countless reasons why exchange rates are important to keep in mind. They play such a considerable role in global economy and market economy, as well as the individual finances of investors. For this reason, it would be important to know what these rates can be influenced by. Here are the top four greatest influences of exchange rates.

1. Inflation

Lower inflation rates allow a country to obtain greater purchasing power. This leads to a higher value of currency as well as raised interest rates. 1950-2000 saw countries like Germany, Switzerland, and Japan experiencing low inflation. This was closely followed by the United States and Canada’s obtainment of lower inflation in the 21st century.

2. Interest rates

Higher interest rates bring appeal to a currency, becoming particularly appealing to foreign investors. This is because the higher the interest rate, the higher the return an investor will procure in comparison to other currencies. Higher interest rates cause exchange rates to become higher, while lower interest rates inevitably cause exchange rates to fall. Interest rates are influenced by inflation, and vice versa.

3. Deficits

A deficit in the world of foreign exchange is caused by an imbalance in the trade of two countries. The trade of two countries involves importation and exportation. Each country specializes in producing or gathering products that are unique to their region and may be valuable to other countries. These are a country’s exports. However, there are also goods that a country is lacking and requires for the survival or prosperity of its people. These are called imports.

If a country were to lose the ability to produce its most valuable exports, but continued necessitating the imports of other countries, this would cause a deficit. This deficit is formed due to the fact there would be less intake of foreign currency stored in the central bank as payment for exports. If a country pays more for imports than they receive from their exportation, a deficit occurs, and the respective currency drops in value. This consequently changes the exchange rate between two countries.

4. Debt

Foreign investors greatly effect the exchange rate a country may hold. This means that anything that may deter foreign investors from maintaining their investments with a certain currency or beginning an investment at all, will inevitably effect exchange rates and lower the value of said currency.

Debt is a critical factor when it comes to gaining or losing foreign investors. When a given country is in debt, high inflation comes along with it. In order to raise its funds with foreign currencies, they are obligated to lower prices.

The biggest fear of foreign investors is the thought that a country in debt may default on its obligations, leaving the investors of their currency high and dry. For this reason, as soon as a country shows signs of large debt, foreign investors try to pull their investments quickly before a default becomes a viable option.

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