Overview of Influences
Forex Prices are determined by a number of factors and are the best indicators of the health of a country’s economy. Basically, higher exchange rate makes exports costly and imports cheap for a country. A lower exchange rate does the opposite: exports cheap and imports expensive. This affects the balance of trade between nations and higher exchange rates usually mean that the balance of trade would not be in the country’s favor.
Besides inflation and interest rates as indicators, exchange rates are also very closely watched by governments to get an idea on economic health and also set policy. This is at the macro level – at the micro level, fluctuations in the value of a currency affects the net worth of investors in every country. Let’s take a look at all the factors the influence exchange rates.
Exchange Rate Determinants
Several important factors influence the price of a currency. A fact to be noted is that exchange rates are relative numbers and a comparison between currencies. Across the board, the same factors determine the price of all world currencies.
- Inflation: a country with consistently low inflation will have a higher currency value – a lot more goods can be bought for a set amount. Countries with high inflation rates will definitely have a depreciated currency as compared to countries they trade with. Inflation happens when goods are few and demand is high.
- Interest Rates: The central bank of a country manipulates interest rates to keep inflation down. This in turn will keep the exchange rate stable. High interest rates are good because this brings in investment from within the country and overseas. If inflation is high, interest rates will be lowered and investments are lower.
- Current Account Deficit: A Current Account refers to the payments that are exchanged between countries for goods and services and also interests paid on investments. A deficit indicates that countries are spending more to borrow money to fill the gap. A high demand for foreign exchange will adversely impact the country’s currency.
- Public Debt: A large amount of borrowing or public debt leads to inflationary tendencies in countries. In the short term deficit financing may stimulate the economy, but outsiders will not want to invest in such a place. A country’s debt rating is an important factor in fixing the exchange rate.
- Political Stability: Foreign investors put their money and get good returns – so they will look at factors like good economics and performance. Another factor that helps to get investment is if a country is exporting more than it imports.
In conclusion, exchange rates are a complex issue and many economists are trying to get a handle on how they work. Investors should read and try to keep up with the markets and then invest smartly.