It is imperative to have the knowledge and understand the factors that have an impact to the exchange rates in order to improve our understanding on how the foreign exchange market works. The foreign currency exchange rate is considered one of the various factors that help determine a country’s economic status.
Well, the foreign exchange rates, relative to any given currency are determined by factors such as supply and demand. Those two factors, supply and demand, are also influenced by a number of other factors, which can lie in either of the categories below.
Economic Factors Affecting Foreign Exchange
Inflation, current account levels and trends, interest rates are some of the economic factors, which affect the foreign currency exchange rates. Also, a country’s government budget deficit or surplus, and economic growth play a part in as far as influence on the exchange rate is concerned.
How does each of the above-mentioned factors work on affecting the currency exchange rates?
Current Accounts Level
Current accounts show the balance of trade between two countries. It also includes all the transactions (read payments) between them for any good or services, or interests and dividends. Therefore a deficit in a country’s current account means that the country spends more that it earns therefore further indicating that the country needs more foreign capital. This therefore affects the country’s exchange rate downwards. If the current account were surplus, then the opposite result would be seen.
In any country, high interest rates translate to attractive investment opportunities, especially to foreign investors. This therefore gives the exchange rates a significant boost thus it’s evident that the exchange rate and the interest rates are related.
Differentials in Inflation
The inflation rate of an economy normally bears an inverse proportion with the value of a given currency. A high inflation rate points to low purchasing power in relation to the currencies. The same logic applies to a country that is having low inflation rate: the currency will have a nigh value since that particular currency’s purchasing power is high in relation to other currencies.
This is another key factor that affect the foreign exchange of a given nation. The GDP growth of a country, employment data and retail sales too have an impact on the country’s foreign currency exchange rate.
Government Budget Deficit/Surplus
A huge deficit on a government’s budget has adverse effects on the country’s exchange rate. This is because the global market particularly reacts negatively to such national spending trends of any given country. Why so? When a country has a budget deficit, the default risk premiums for securities in that particular currency rise, consequently resulting to less attractive investments. A collapsing government budget deficit will have the opposite impact – or much better, when the government’s budget surplus is expanding, the foreign exchange rate of its currency will grow competitive.
Political Factors Affecting Foreign Exchange
Any foreign investor anywhere is keen to invest in a safe country where political stability prevails. An unstable political environment translates to an unstable economic environment and it’s hard for enterprises or businesses to thrive in such countries. Country’s experiencing persistent political turmoil has lowly competitive exchange rates on their national currency.
Foreign traders wishing to succeed in the trade must be ready to internalize the above factors. Although the above do not form the bulk of all the factors determining foreign exchange rates, they certainly form the pillars for all the other factors.