Factors that Influence Foreign Exchange Rates
The foreign exchange rates, just like other financial assets, fluctuate every day as the demand and supply of different currencies changes. These changes in exchange rates affect everyone either directly or indirectly. In this article we will look at some of the important factors that influence the exchange rates. The factors are presented in no specific order.
A country with low inflation rate compared to another country will see its currency appreciate compared to the other country. This is because in the country where the inflation rate is low, the prices of goods and services are increasing at a slower rate. That country’s exports will become more competitive thereby increasing the demand for that currency. At the same time the foreign goods in that country will become less competitive and imports will reduce, thereby decreasing the demand for the foreign currency.
A higher interest rate causes the country’s currency to appreciate. This is because the country with higher interest rates can offer better rates to lenders thereby attracting more foreign capital, which causes the exchange rates to rise.
Balance of Payments
The changes in current account also impact the value of currency. A current account deficit indicates that the country’s value of imports is more than the value of exports. Therefore, to balance the trade it requires more foreign currency than it receives through exports. The country will therefore borrow foreign capital which will increase the demand for foreign currency and the domestic currency will depreciate. This can be changed only by either increasing exports by making the goods more attractive/competitive or by reducing imports.
A country with huge public debt attracts less foreign capital. This is because high public debt leads to increase in inflation which erodes the country’s currency value. Additionally if there is a risk of default by the country, investors will sell their bond holding in the open market. This leads to a depreciation of the currency value.
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