Apart from factors like interest rates and inflation, the currency exchange rate is one of the most significant factors that are commonly used to determine the state of health of a country’s economy. Exchange rates contributes immensely to the amount of trades that goes on in the country and this a very significant factor for the global free market economy. Because of this, exchange rates are one of the key factors that are frequently investigated, analyzed and manipulated through the government policies. In this article, we are going to look at the most important factors that contribute to the change in exchange rate.
1. Degree of difference in Inflation
A country with constant lower interest has a higher currency value and increases the purchasing power with regards to other currencies. Countries with higher inflation basically experience currency depreciation relative to the currencies of their trading partners and this is commonly followed by a high interest rates.
2. Degree of difference in Interest Rates
Interest rates, inflation and exchange rates are very much related to each other. Through interest rates manipulation, central banks of a country control the inflation and exchange rates, and altering interest rates have effects on inflation and the value of currencies. Higher interest rates provide lenders in a country a huge return more than other countries. As a result of this, higher interest rates boost foreign investments and leads to an increase in exchange rate. The exchange rate increase is minimized if inflation in the country is higher than what is obtained in other countries. The reverse is the case for low interest rates which tends to make exchange rate to fall.
3. Public Debt
Countries commonly carry out large-scale deficit financing to offset the cost of public sector projects and governmental funding. Although this action commonly makes the country’s domestic economy better, such debts may discourage foreign investments. This is because such debts can trigger inflation and when the rate of inflation increases the debt will be serviced and eventually paid off with less costly real dollars in the future.
When the situation gets worst, a government may mint new currency to offset part of a large debt, however raising the money supply invariably causes inflation. Nevertheless, when a government cannot service its debts by the local means, it may allocate more securities for sale for sale to foreigners, thereby lowering their prices but foreigners may be unwilling to own securities the particular country currency where they believe the default risk is substantive.
4. Terms of Trade
Terms of trade is a ratio that compares export prices to import prices. The terms of trade is connected to current accounts and the balance of payments. If the price of a country’s exports increases by a higher rate than that of imports, the country’s terms of trade is enhanced. Increase in terms of trade illustrates higher demands for the export of a country. This invariable causes the revenue from exports to increase and make the demand for the country’s currency to increase leading to a boost the value of that particular currency. When the price of the country’s export is less than that of imports, the value of the country’s currency will fall with regards to other countries it trades with.
5. Political Stability and Economic routine
Foreign investors without doubt look for countries with stable economies to invest in. Countries that are stable economically and politically would attract further investments. Investors tend to move their money away from politically fragile countries and transfer it to economies that are more stable.
6. A country’s Current Account Deficits
The current account is the balance of trade between one country and other countries it trades with. It measures the entire payments between countries for goods, services, interest and dividends. A current account deficit implies the country imports more than it exports and implies that the country is borrowing from foreign countries to make up for its deficit. This commonly reduces the exchange rate for the country’s currency.