Determinants Of Foreign Exchange Rates: Forex
A country’s foreign exchange rates are an indication of its economic
health. Its exchange rate plays a very important role in its trade level.
It is for this reason that rates are constantly scrutinized, analyzed and
at times manipulated by government departments. For the individual
investor, these rates often have an adverse effect on their portfolios.
Trading activities between countries are the main factor that affects
currency rate fluctuations. When a country shows an increase in its
currency rate, its export prices will increase, and its import prices will
drop in the foreign market. The reverse is true when a country has a low
If a country has a low exchange rate, its trade balance will increase.
However, a high exchange rate will decrease its trade balance.
Current Account Deficit
The trade difference between a country and its trade partners is termed as
a ‘current account.’ It shows the difference between payments made from one
country to another for interest, dividends, goods, and services. A deficit
in a country’s current account shows that it is spending more on foreign
trade than it is earning from other countries. This indicates that a
country requires more foreign currency than it is earning from its exports.
This means that the demand for its products is not very high.
The correlation between inflation, interest rates, and foreign exchange
rates is extremely strong. If central banks make the decision to manipulate
interest rates, there is a direct influence on inflation and the currency
exchange rate. By raising the interest rate, lenders achieve a higher
return than in other countries. This attracts investment from foreign
countries which causes an increase in the exchange rate. When interest
rates are brought down, the return for lenders decreases which bring down
the exchange rate.
The interest rates that the central bank sets affect interest rates that
are charged to borrowing clients by their respective financial
institutions. When a country’s economy is underperforming, the central
banks will consider a lowering of interest rates to boost borrowing. The
lower interest rates often cause consumers to borrow more and increase
their spending which aids in a boost of the economy. If the economy becomes
too active, the national bank may increase the benchmark rate which will
cause an increase in the rate for borrowings. This makes borrowing
expensive which will slow down consumer spending.
If a country has a consistently low inflation rate, its currency value will
increase. This is so because the country’s purchasing power increases in
relation to foreign currencies. The countries who maintained low inflation
rates during the past fifty or so years are Germany, Japan, and
Switzerland. Low inflation in North America was only achieved much later.
Countries that have a high inflation rate experience a dip in their
currency rate as opposed to their trade partners. This phenomenon is linked
to high-interest rates.
There are a huge number of factors that determine a country’s exchange
rate. These are complicated enough to leave many experienced traders
confused. If you are an avid investor or foreign currency trader, you
should become familiar with concepts that determine currency values. These
rates will have a dramatic effect on the return on your investments.
Foreign currency exchange rates are determined by several factors and this
not only affects trading between countries, it also affects the individual
consumer in several ways. Corporations who trade with other countries are
also affected negatively at times.
The regular movement of the forex rate affects everyone regardless of
whether you are traveling to a foreign country or buying an item online.
Every commodity is affected by the economic law of supply and demand and
the forex rate is not any different. The demand and supply of a country’s
currency are reflected in its foreign exchange rate.
During dips in the economy, consumers do not spend as much as they would
during an economic upswing and this affects international trade. This
causes a country’s currency exchange rate to decline compared to countries that are not
in the throes of an economic downslide. If a country experiences a boost in
its economy, the value of its currency will also receive a similar boost,
unless its government decides to take action.
The growth of the Economy
A country’s economy must expand in order for it to meet the growing needs
of an increasing population. The problem that arises is if the growth is
too rapid. This causes an increase in commodity prices to overtake
increases in salaries. This, in turn, causes consumers to decrease their
spending even in cases where workers have received wage increases.
Most countries set an annual growth in its economy at a targeted 2%. In
cases where the growth percentage is higher than this target, the inflation
rate will increase. In this instance, the central bank of the country will
take steps to increase the interest rates. Increasing the interest rate
causes an increase in the borrowing cost. This causes consumers to decrease
their borrowing which slows down general spending trends. Traders can use
this to their advantage as a change in the interest rates. This is
indicative of a change in the foreign currency exchange rate.
During times of deflation, the opposite is true and it is normally a sign
that the country’s economy is in the process of stagnation. National banks
tend to lower interest rates during these times in order to increase
consumer spending. The banks undertake this process to try and reverse
This fluctuation is relevant to investors looking to gain solid returns on
their funds. Asset yields in a currency are normally increased with an
increase in interest rate. This causes a demand by investors for that
currency and ultimately causes an increase in the currency’s exchange rate value. In
times when interest rates decline, investors shy away from the currency as
they will not be getting a satisfactory yield.
The effect these factors have on currency rates is important for forex
brokers. Traders should keep an eye on interest rates and the economic
climate of the currency pairs they are trading.