Factors which influence exchange rates

Before you undertake currency investment, it is important you understand the forces that drive
exchange rates. Many of these factors are intangible and/or psychological, and, thus, are
impossible to characterize. However, those factors which are generally recognized as
fundamental determinants are spelled out below. 

1. Inflation                     

A low rate of inflation, relative to other countries, implies that prices of goods in services in one
country are increasing at a comparatively slow pace. These goods and services then appear
cheaper in the eyes of foreigners, who increase  demand. If the law of purchasing power parity
holds, the nation’s currency should appreciate to offset the relative decrease in prices.

2. Interest Rates

The correlation between a nation’s interest rate and its exchange rate is easy to grasp. We would
expect savvy investors to invest their money where, for a given level of risk, the returns are
highest.  Thus, when a disparity in interest rates exists between countries whose risk of default is
equal, investors would likely lend to the country that was offering the higher interest rate.  In
order to invest in or lend to another country, one must first obtain that nation’s currency.  This
increases demand for that nation’s currency, and causes it to appreciate in value.         

3. Current-Account / Trade Balance

When a country runs a current account deficit, it typically means that the nation imports more
than it exports. This tends to skew the exchange rate in favor of the country that runs a trade
surplus, as foreign demand for its currency must be comparatively high. In due course, the
exchange rate may adjust so as to make the first nation’s products affordable to foreigners, and
bridge the gap between imports and exports.

4. Public (government) debt

The relationship between government debt obligations and its exchange rate is not as cut-and-
dried. Basically, government borrowing to finance deficit spending increases inflation, which
literally eats into the value of that nation’s currency. In addition, if lenders believe there is any
risk of default, they may sell the debt (in the United States, this debt takes the form of treasury
securities) on the open market, exerting downward pressure on the exchange rate.

5. Political and Economic Factors

Most investors are risk-averse; accordingly, they will invest their capital where there is a certain
degree of predictability. They tend to avoid investing in countries that are typified by
governmental instability and/or economic stagnation. In contrast, they will invest capital in stable
countries that exhibit strong signs of economic growth. A nation whose government and
economy are perennially stable will attract the most investment. This, in turn, creates demand for
that nation’s currency and causes its currency to appreciate in value.

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