Factors that Influence Exchange Rates

Foreign exchange rate is among the most important indicators of a country’s relative economic health level. The forex rate of the country offers a window to the stability of its economy. Thus, it is always under close watch and scrutiny. For example, if you need to receive or send money denominated in foreign currency, you need to get updated on the prevailing exchange rates.

Exchange rate can be defined simply as the value at which the currency of one country can be converted into the currency of another country. The rate may fluctuate on a daily basis due to the influence of market forces that include the supply and demand of one country’s currency to another.

So, exactly what affects exchange rates? This section will cover some of the main factors that cause the fluctuations and variations in exchange rates. We will explain the reasons for the currency rates’ volatility to help you better appreciate the best times to engage in foreign currency exchange.

Major Factors that Affect Exchange Rates

  • Inflation Rates – Shifts in market inflation can, in turn, cause currency exchange rates to fluctuate. A country that has a lower inflation rate compared to another country will experience an increase in its local currency’s value. When inflation is low, the cost of goods and services rise at a slower pace. An economy with a sustained low inflation rate will show an appreciating currency value. On the other hand, a country that has a high inflation rate will often experience decline in its currency’s value that is often accompanied by a higher interest rate.
  • Interest Rates – A change in interest rates can affect the value of a currency and its exchange rate with the dollar. Inflation, foreign exchange rates, and interest rates are all correlated. A hike in interest rates triggers the appreciation of a country’s currency because a higher interest rate offers a bigger profit for lenders, and this attracts more foreign investments that cause a corresponding hike in exchange rates.
  • The Current Account/Balance of Payments of a Country

A nation’s current account represents the balance of its trade, as well as its earnings from foreign investments. It is the sum total of all its transactions, including imports, exports, and debts, among others. A current account deficit because of higher spending on imports compared to earnings through exports will trigger depreciation. The balance of payments can cause its local currency’s exchange rate to fluctuate.

  • Government Debt – Government debt is the national or public debt that the central government owes. A country saddled with heavy government borrowing is less likely to attract foreign capital, and this will lead to inflation. Foreign investors are likely to dispose of their bonds on the open market if government debt within the specific country is predicted. This will result to an inevitable drop in the value of the country’s currency.
  • Terms of Trade – Relative to the balance of payments and current accounts, the terms of trade is simply the ratio between export and import prices. The terms of trade of a country will improve once the prices of its exports rise over the prices of its imports. The result is higher earnings for the country that will cause a higher demand for local currency and a subsequent appreciation in the value of the currency. The exchange rate will improve as well.
  • Political Performance and Stability – The state of a country’s politics and the performance of its economy have a bearing on the strength of its currency. If a country has a low risk for political turmoil, it will be more attractive to foreign investments, drawing investors away from other competing countries that have less economic and political stability. With the increase in foreign investments, an improvement in the domestic currency’s value will ensue. A country characterized by sound trade and financial policy will have no room for doubt in its currency value. However, a country with a propensity for political uncertainty can expect a drop in exchange rates.
  • Recession – When an economy is under recession, it is certain that its interest rates will drop, further dwindling its chances of getting foreign capital. The local currency will weaken against other currencies as a result. The exchange rate will also go down.
  • Speculation – If a rise in a country’s currency is imminent, there will be more demand from investors for the local currency in hopes of making a significant profit in the future. The result? An increase in the currency’s value because of the higher demand. The increase in value will soon be followed by a rise in the exchange rate.

Final Word

These are the major factors that dictate the fluctuations in foreign exchange rates. If you often receive or send money in foreign currency, understanding these factors will give you a good idea on the best times to engage in money transfers. To keep you from encountering potential problems brought about by currency rates, always go for locked-in exchange rate services. This will make sure that your currency will be converted at the expected rate even in the presence of any of the factors that may cause unfavorable fluctuations.