What Affects Foreign Exchange Rates?

What Affects Foreign Exchange Rates?

Foreign exchange rates affect everyone, irrespective of whether you are trading in the forex market, planning an international holiday, purchasing goods from abroad or simply buying goods from a local store that have been imported from another country.

A currency’s value goes up and down in response to supply and demand.  Consumer spending affects the supply of money.  In cases where a country’s economy has faltered, its consumer spending drops and other countries diminish trade with that country.  This leads to a drop in that particular country’s currency compared to other global currencies that have stronger economies.  Conversely, a strong economy lifts the value of a country’s currency, unless the government intervenes to restrain that growth.

Economic Growth and Foreign Exchange Rates

It is imperative that a country’s economy grows to meet the needs of its growing population.  If this economy expansion is too rapid, the price will exceed wage increases which will diminish the buying power of the individual.  Most countries aim for a steady economic growth of around 2% per annum.  In cases where the growth is higher, it will cause an increase in inflation.  This may cause the central bank to increase interest rates which effectively increases the rate of borrowing.  This is normally done to try and slow down spending in the country.  When the interest rates are changed, it generally leads to a change in foreign exchange rates.

The other side of inflation is deflation and it happens during recessions.  This is normally indicative of an economy that is stagnating.  In this instance, central banks will lower the interest rates to try and boost the spending habits of consumers.

Central Banks

Other than manipulation of the interest rates, central banks often need to take a more drastic measure to influence growth of the economy.  They often venture into quantitative easing to increase the supply of money in the economy.  This involves purchasing government bonds and other financial instruments from the financial institutions to allow the banking system to become more liquid.  This is normally done as a last resort if the interest rate lowering method fails to adjust the economy effectively.  There is risk attached to this method of boosting the economy as an increase in the money supply could cause that currency to devalue.

Balance of Trade

A country’s trade balance is calculated by the total value related to its exports, less the total value related to its imports.  If this indicates a positive figure, the country has a favourable trade balance.  If it is negative, the country is said to have a trade deficit.  A country’s balance of trade has a direct impact on the demand and supply of a particular currency.  In the event that it has a surplus, the demand for its currency increases as foreigners need to use more of their home currency to buy that country’s goods.  In the case of a deficit, the country requires more of its own currency to trade and that could cause the currency to be devalued if the supply far outweighs the demand.

 

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