The 3 determinants of exchange rates

The 3 determinants of exchange rates

The exchange rates of a country constitute an indication of its economic health. Its exchange rate plays a very important role in its commercial level.

It is for this reason that rates are constantly examined, analyzed and sometimes handled by ministries. For the individual investor, these rates often have an unfavorable effect on their portfolios.

Commercial activities between countries are the main factor that affects fluctuations in exchange rates. When a country shows an increase in its exchange rate, its export prices will increase and its import prices will fall on the foreign market.

The opposite is true when a country has a low exchange rate. If a country has a low exchange rate, its trade balance will increase, but a high exchange rate will decrease its trade balance.

1. 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.

2. 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.

3. Inflation

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.

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