What Affects Exchange Rates?

Foreign Exchange rate, or as it is more commonly known, Forex rate (ForEx), is one of the key deciding factors of a country’s financial health. It helps in determining the economic health of a nation and gives indication of a country’s economic stability.

Foreign Exchange

Forex rates are constantly monitored, especially when making overseas transactions to ensure maximum benefit while transferring, or receiving international payment.

Forex Rate in simple terms is the rate at which your currency is valued, when converted into a different currency. These rates fluctuate daily. The fluctuations are due to a variety of factors like change in market forces, supply and demand of currency and as we are now observing, a pandemic and its effect on various industries.

In order for you to attain the most benefit of your international transaction, it is important to understand what affects exchange rates. In this article, we will explore not only the variation that leads to fluctuations and affect the exchange rates, but also the underlying causes and the reason for their volatility.

Following are the Factors that Affect Exchange Rates:

Inflation Rates

A country that has low inflation. Which means, a country where the cost of goods and services is growing at a slow rate will see an appreciation in the value of its currency. A consistently low inflation rate helps in strengthening the value of the currency, thus helping in favorable exchange rates. On the other hand, a country with high inflation will see depreciation in the value of the currency and will attract higher interest rates. A high inflation rate is one of the major factors that affect forex rates.

Interest Rates

A higher interest rate is extremely attractive to lenders, as it promises a higher financial reward. This means that a country’s currency is appreciating in value and it also helps hold a favorable position, when compared to the dollar. Increase in interest rates make for lucrative opportunities. This attracts foreign investment and leads to a surge in exchange rates

Country’s Current Account/Balance of Payments

Just like with a business, a country’s current account is a reflection of all the trades it conducts and its earnings through imports. A country’s current account should consist of all its transactions, which includes exports, imports and debt. A country is in deficit when it spends more of its currency on importing products than what it is earning through exports. This deficit causes currency depreciation. All the balance payments a country makes invariably causes a fluctuation in the exchange rates of its currency.

Government Debt

Government Debt or National Debt is public debt that is owned by the central government. The higher the debt, the less likely it will be for a country to secure foreign capital, which inadvertently will lead to inflation. This does have an effect on exchange rates. How? Well, if the market predicts that a country is expected to incur government or national debt, foreign investors will sell their bonds in open markets. Consequently decreasing the value of the currency and forcing a change in exchange rates.

Terms of Trade

Terms of trade, in layman terms, is the ratio of export prices of a country, in comparison to its import prices. As a country’s terms of trade improves, it signals a favorable increase in its export prices, specifically when compared with its import prices. This means, a higher revenue and an upsurge in the demand for the country’s currency. A higher demand for a currency will always lead to an appreciation in its value. This appreciation is reflected in the exchange rate of the currency.

Political Stability

The political stability of a country is a powerful indicator of its economic strength, which can also be seen in the valuation of the currency. A politically stable country promises a powerful and reliable economic performance. A country with less to no risk of political turmoil is always a lucrative option to foreign investors. This not only means that the country will secure foreign investment, but it will also draw investment away from other countries. Increase in foreign capital leads to an appreciation in the valuation of the domestic currency.

Favorable political and economical conditions lead to strong financial and trade policies. These policies strengthen the value of the domestic currency, leaving no room for uncertainty. In comparison, a country with political instability will lead to a lot of ambiguity in its decision making and policies. This ambiguity leads to confusion, which detracts foreign investment, causing a depreciation in forex rates.

Recession

Recession is something we have all experienced a decade ago, and now again with the outbreak of the COVID-19 pandemic. A recession affects everything. When a country is in recession, the interest rates plummet. Which means, the likelihood of attracting foreign investment is low. A lower likelihood of exchanging foreign investment weakens the currency, especially when compared to countries not in recession, thereby adversely affecting the exchange rate.

Speculation

As the word suggests, speculation is a forecast or in this case, more an expectation that the value of a currency will rise. Investors will look to invest more in a currency that is expected to increase in value, so they can make a profit. This is how speculation about an increase in the value of currency leads to a rise in the exchange rate of the currency.

Conclusion

In conclusion, all of these factors cause fluctuations in the foreign exchange rate. So if you are someone who makes or receives international payments, keeping an eye on these factors will help you better plan your international transfers and help save money. Perhaps, it might even make some money the next time you make or receive an international payment.

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