Factors That Affect Foreign Exchange Rates

The value of a currency is determined by many factors, including the country’s economic strength, political stability, and ability to attract foreign investment.

The global economy is interlinked by trade. While only a few currencies get the largest share of trade volume, almost all currencies worldwide are traded at foreign exchanges. This is because a constant flow of currencies is necessary for a smooth trade.

The exchange rate of a particular currency is an essential determinant of the country’s economic health. Therefore, countries with stable currencies are also most likely to have stable credit and healthy trading levels.

What are the primary factors affecting foreign exchange rates?

• Economic conditions
• Political events
• Central Bank policy
• Trade practices
• International Monetary Fund

Economic Conditions

A strong economy will usually lead to higher prices for goods and services. This means that people who live in countries with stronger economies tend to spend more money than those with weaker economies. As a result, the exchange rate between the two currencies will move toward parity.

Recession

A recession has far-reaching effects on the economy of a country as a whole. The first area of the economy that is affected is the realm of interest rates. When the interest rates fall, the country becomes less inclined to acquire foreign capital. This, in turn, results in a lessened supply of foreign currency.

These results are a less attractive local currency at the exchange market. The exchange rate of the local currency thus goes low to respond to the low demand.

Inflation

Inflation is also correlated with interest rates. Inflation is the general increase in the price of commodities in the market. The forex market responds to the change in prices in the market indirectly.

The increase in price levels affects the demand for goods negatively. When goods are not being demanded in huge volumes, the currency’s value decreases, leading to low demand in the foreign exchange market. Lower inflation is thus necessary to increase the value of the local currency.

Central Bank Policy

Central banks play a significant role in influencing exchange rates. They set interest rates, which affect how much money people save and spend. This influences the demand for foreign currency, which determines its price.

Interest Rates

Interest rates can cause the exchange rates of currency to increase or fall. Interest rates work in tandem with inflation. Forex rates are affected by interest rates because of demand. When interest rates change, the level of lending and borrowing is affected. Lending, in turn, determines if the country will be able to attract foreign capital. If the change in interest rates leads to a bigger inflow of foreign capital, then the exchange rate of the local currency goes high.

National Debt

The debt by a government can determine its level of borrowing. Additional borrowing becomes a challenge if a country already has a considerable obligation. With foreign capital not flowing into the country, high inflation ensues. This, in turn, leads to the depreciation of the local currency.

The level of trust in the government by foreign investors also goes low when there is a huge national debt. The national debt is thus a major factor in determining the exchange rate of a currency.

Political Stability

In addition to the strength of an economy, political events also affect currency values. If there is a war, trade embargoes, or other international travel restrictions, the exchange rates of different currencies will fluctuate. Therefore the political situation in a country is also important when determining the exchange rate. Investors always look to invest in places where the security of their assets is guaranteed.

Countries with a lot of political instability are thus less likely to attract foreign investment. Moreover, since foreign investment comes with an inflow of foreign currency, the lack of it means that the local currency will be of less value in the foreign exchange market.

A country attracting large amounts of FDI will also see its currency attract a strong exchange rate.

Trade Practices

Several trade practices affect the value of currencies. Let’s have a look at a few of them.

Interest rate differentials

As aforesaid, a country with a higher interest rate will attract more investment than one with a lower rate.

Foreign direct investments (FDI)

FDI refers to when companies invest abroad rather than domestically. It impacts the value of a currency because it creates jobs and adds to the economy.

Balance of payments

As mentioned earlier, the balance of payments shows the difference between what countries owe each other and what they receive. If there is a deficit, then the value of the currency decreases.

The terms of trade also influence the exchange rate of a particular currency. This is because business terms are somehow related to the balance of payments. While the balance of payments is the general difference in the inflow and outflow of commodities, the terms of trade specifically refer to the ratio of export prices to import prices.

When this ratio is high, there is a higher demand for local currency, strengthening it in the forex market. A lower ratio also has the opposite effect.

International Monetary Fund (IMF)

The IMF is a global organization that provides financial assistance to developing nations. Formed in 1944, today, the IMF has 190 countries as members with a focus on ensuring they have enough access to enough foreign exchange to trade beyond their shores. They also advise governments on managing their economies and using their reserves to help member countries pay off debts to keep trading.

Final Words

Globalization has improved the exchange of goods and services between trading nations. However, fluctuation in exchange rates impacts prices paid for exports and imports. Weaker currencies pay more for imports but benefit from higher demand for exports. Many elements affect foreign exchange rates, notably economic conditions and political events.