Determinants Of Foreign Exchange Rates: Forex

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 is 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 currency rate.

If a country has a low exchange rate, its trade balance will increase, but 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.  It is also indicative of the fact that a country requires funding from foreign sources to get rid of its deficit.  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.

Interest Rates

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 brings 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.

The foreign currency exchange rates linked to your investments will be the determining factor of the actual value of your investment portfolio.  There are a huge number of factors that determine a country’s exchange rate and 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 travelling 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 is 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 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 receive a similar boost, unless its government decides to take action.

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 is indicative of a change in the foreign currency 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 deflation.

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 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.

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