Six factors that determine currency exchange rates

Understanding the forces that influence currency exchange rates is key for successful Forex trading. In this type of market, currency acts a commodity, so the laws of supply and demand are fully applicable to it. The differentiating feature of foreign exchange market is the absence of a single means of payment, as a result exchange rates are formed relative to each other. To predict fluctuations in Forex rates and quotations, one should pay attention to the factors that regulate supply and demand. The processes occurring in the market may depend on many components and each factor may have a different impact. The study of global factors will help to achieve success as a forex trader.

It is common knowledge, that value of the currency of any country depends on the state of the economy, financial system and even political structure. The differences in the development in these areas forms exchange rates. In this article we will review the main factors that have a long-term impact on currency exchange rates. Short-term impact on the movement of exchange rates can have a large number of trade participants: banks, Forex market brokers, various funds.

Difference in inflation levels

The rate of inflation indicates the degree of depreciation of money during a certain time period. The currency of countries with low inflation is usually valued higher, and its rate is more stable. For example, in the United States, the inflation rate does not exceed 2% per year, and the US dollar has become the main currency in international settlements. There is no inflation in Japan, and even the opposite process is observed – deflation. Therefore, the Japanese yen (see the USD JPY chart) is often bought as a reliable currency “shelter” that can protect money from depreciation. Conversely, the currency of countries with high inflation is often devalued and its rate is unstable. Inflation rates in different countries can vary greatly, but this is only one of the factors influencing the exchange rate.

Differential of interest rates

The level of interest rates in the banking system of the state significantly affects the state of the entire economy and financial sphere. Inflation and exchange rate directly depends on the interest rate. By manipulating the interest rate, the state through the central bank influences the rate of national currency and the rate of inflation. Raising interest rates attracts foreign capital, which causes a rise in the exchange rate. For example, the growth of the US Federal Reserve rate increases the yield of government bonds. Japanese investors buy more bonds, which requires US dollars, the demand for them increases, and the dollar against the yen is growing. A decrease in interest rates revives the economy, boosts inflation and lowers the exchange rate. So, after the crisis of 2008, the European Central Bank reduced the discount rate to zero, and the euro against the dollar fell from 1.5 to 1.04.

Trade balance deficit

Any country buys abroad a certain amount of goods. Similarly, national goods are sold to other countries. In addition, there is a movement of funds in the form of payment for services, income from tourism and the like. If a country, in general, spends more foreign currency than it receives, a trade balance deficit arises and fundamental analysis is included in the work. The demand for foreign currency increases and the exchange rate rises. To fill the deficit, it is necessary to borrow capital from foreign sources, which destabilizes the national currency and reduces its rate. The surplus or balance of foreign trade ensures the stability of the exchange rate.

State debt

The money intended for the functioning of the state is collected in the state budget. Most states do not have enough funds to finance all items of expenditure, or the money is received unevenly. To close the deficit and timely pay all bills, the state borrows money in domestic and foreign financial markets. This happens in the form of issuing bonds with fixed returns. These bonds are then traded in a free market where they can trade above or below par. The value of bonds can affect exchange rates, reflecting the demand for bonds of a particular country. Thus, the growth of American "treasuries" always causes a rise in the dollar.

Public debt does not always uniquely affect the economy and the exchange rate. Increasing the yield of government bonds attracts foreign capital and can help revive the economy. The worst option is when the state tries to reduce the budget deficit by issuing bank notes. An increase in volumes inevitably leads to inflation and a depreciation of the national currency. There are known cases of hyperinflation, when money has depreciated thousands and millions of times.

Difference of import and export cost

Changes in world prices for raw materials, energy, food products can also affect exchange rates. If a country exports oil and buys food, then with a decrease in oil prices, its balance of payments will deteriorate and the currency will become cheaper. If the food also becomes cheaper, the balance will not change. If the price of exports grows faster than imports, then the balance will improve, and the exchange rate will rise. There is even the concept of "commodity currencies". This, for example, the Canadian dollar, depending on the price of oil, or the Australian dollar, which varies in accordance with the prices of metal ores and coal. Although the Russian ruble is not called the commodity currency, it correlates significantly with the price of oil and gas.

Influence of political stability and economic efficiency

The political stability of the state attracts foreign investors and increases confidence in the country's currency. Political upheavals, civil wars, riots have a negative impact on the rate of the national currency. In a country with an unstable political situation, risks for foreign investors and international trade increase and this causes an outflow of capital and a shortage of foreign currency. Political stability is closely linked to the economic efficiency of the state. If legislators establish laws that promote economic and financial development, conditions for trade and investment will improve and this in turn ensures the stability of the national currency.

Author: Kate Solano,
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