6 Factors that affect the exchange rate

6 Factors that affect the exchange rate

Apart from factors such as interest rates and inflation, the currency exchange rate is one of the most significant determinants of a country’s relative level of economic health. Exchange rates play a key role in the degree of exchange in a nation that is important to most of the free-market economies in the world. For this reason, exchange rates are among the most frequently tracked, evaluated, and governmentally controlled economic indicators. Yet exchange rates often matter on a smaller scale: they have an effect on the actual return of the investor’s portfolio. Here, we’re looking at some of the main powers behind exchange rate movements.

Overview of the exchange rate

Before we look at these powers, we should explain how exchange-rate changes impact a nation’s trade ties with other nations. Higher priced currency makes imports less costly and exports more competitive in international markets. Lower-valued currency makes imports of a nation more costly and exports less costly in international markets. A higher exchange rate can be expected to worsen the trade balance of a country, whereas a lower exchange rate can be expected to improve.

TAKEAWAYS KEY

  • Apart from factors such as interest rates and inflation, the currency exchange rate is one of the most significant determinants of a country’s relative level of economic health.
  • Higher priced currency makes imports less costly and exports more competitive in international markets.
  • The exchange rate is subjective and interpreted as a measure of the currencies of the two nations.

Determinants of Trade Tariffs

The exchange rate is calculated by a variety of variables. Many of these considerations are related to the trade relationship between the two countries. Note, the exchange rate is subjective and expressed as a measure of the currencies of the two nations. The following are some of the key determinants of the exchange rate between the two countries. Note that these factors are not in any specific order; as with many areas of economics, there is much discussion about the relative significance of these factors.

Inflation differentials

Usually, a country with a consistently lower inflation rate has an increasing currency value as its buying power rises compared to other currencies. Over the last half of the 20th century, low inflation countries included Japan, Germany, and Switzerland. While the US and Canada experienced low inflation only later. Those countries with higher inflation usually see their currency weakening of their trading partners’ currencies. This is often commonly followed by higher interest rates.

Interest rate differentials

Interest rates, inflation, and exchange rates are all strongly correlated. Through controlling interest rates, central banks have an effect on inflation and exchange rates, and changing interest rates have an effect on inflation and currency values. Higher interest rates give borrowers better returns in the economy compared to other countries. As a result, higher interest rates draw international capital and cause the exchange rate to increase. The effect of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional measures are used to lower the currency. The same is true for lower interest rates – that is, lower interest rates lead to lower exchange rates.

Deficits in current account

The current account is the balance of trade between a country and its trading partners, representing all payments made between countries for products, services, interest, and dividends. The current account deficit shows that the nation spends more on foreign exchange than it receives. Also, that it borrows money from international sources to make up the difference. In other words, a country needs more foreign currency than it receives from export sales. And provides more of its own currency than foreign countries demand its goods. Excessive foreign currency demand reduces the country’s exchange rate; before domestic goods and services are cheap enough for foreigners, and foreign assets are too costly to generate domestic sales.

Debt for the Public

Countries will participate in large-scale deficit financing to pay for public sector programs and government funding. While this operation boosts the domestic economy, countries with high budget deficits and debts are less attractive to foreign investors. The explanation for that? A large debt promotes inflation. If inflation is strong, the debt will be serviced and eventually repaid with cheaper real dollars in the future.

In the worst-case scenario, a government could print money to pay part of a large debt. Although, growing the money supply would eventually trigger inflation. Moreover, if the government is unable to fund its debt through domestic means (selling domestic bonds, growing money supply); it must raise the supply of securities for sale to foreigners, thus reducing their rates. Finally, a large debt may prove to be of interest to foreigners if they assume that the country risks defaulting on its obligations. Foreigners would be less likely to own securities denominated in that currency if the possibility of default is high. For this reason, the country’s debt rating (as calculated by Moody’s or Standard & Poor’s) is a key determinant of its exchange rate.

Economic terms

The ratio of export prices to import prices, the terms of trade are linked to the current accounts and the balance of payments. If the price of a country’s exports increases at a higher rate than its imports, its terms of trade have improved favorably. Greater demand for the country’s exports is rising the terms of trade shows. This, in turn, results in increasing export sales. This also increases the demand for the country’s currency (and increases the value of the currency). If the price of exports increases at a lower rate than its imports, the currency’s value would decrease in relation to its trading partners.

Strong output of the economy

Global investors are increasingly searching for prosperous countries with good economic results to invest their money. A country with such positive characteristics would attract foreign funds away from other countries considered to have more political and economic risks. Political instability can lead to a lack of confidence in the currency and capital movements in the currencies of more stable countries.

The Bottom Line

The exchange rate of the currency in which the portfolio holds the bulk of its assets decides the actual return of the portfolio. Decreased exchange rates obviously minimize the buying power of profits and capital gains resulting from any returns. In addition, the exchange rate affects other income variables, like interest rates, inflation, and even capital gains from domestic securities. Although exchange rates are calculated by a variety of complex factors that often leave even the most experienced economists flummoxed. Investors should still have some understanding of how currency values and exchange rates play an important role in the rate of return on investment.