What affects exchange rates of different currencies?

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So, you’ve finally been brought up to speed as far as the currency markets are concerned. Now that you’ve read up on them and the various key terms associated with them, it is time to take a look at the factors that affect the exchange rates of currencies in the currency markets.  While there may be innumerable small and large factors that influence the currency exchange rates on a day-to-day basis, there are some important elements that you should absolutely be aware of. 

Let’s jump right in and see what they are. 

1. Rate of inflation

A consistent increase in the general prices of goods and services over a period of time is termed as inflation. As a consequence of an increase in the prices of goods, the purchasing power of a country’s currency falls. In simple terms, this means that you can purchase fewer goods with the same amount of money when inflation occurs.

For instance, say you can normally purchase 1 kilogram of tomatoes for Rs. 30. With inflation in the picture, this scenario changes. You’ll only be able to purchase 3/4th of a kilogram or even less than that for the same Rs. 30. In other words, 1 kilogram of tomatoes will cost more than Rs. 30.

The rate of inflation of a country has a huge impact on its currency. A high rate of inflation causes the value of a currency to drop and depreciate, whereas a low rate of inflation causes the value to appreciate.    

2. Balance of payments 

Balance of payments is essentially a statement that shows the difference between the inflow of money into a country and the outflow of money from the same country. The statement is generally compiled for a specified period of time. It takes into consideration a country’s imports and exports of goods and services. A deficit in the balance of payments means that the outflow of money is higher than the inflow. This means a country is paying more than it receives. Naturally, in this case, the value of the country’s currency will depreciate.   

3. Government debt 

Also known as public debt or national debt, it is a measure of how much a country’s government owes its creditors. A country’s government, in a bid to finance their yearly budgetary spending, generally borrows money by issuing bonds, T-bills, and other securities. A country with high government debt is more likely to experience a decrease in the value of its currency when compared with a country with low government debt.  

4. Terms of trade

The terms of trade is basically a ratio that indicates a country’s average export prices with respect to its average import prices. Mathematically put, it looks like this.

Terms of trade = (Index of export prices ÷ Index of import prices) x 100

If the export prices of a country are more than its import prices, the value of its currency would increase since it would drive up the demand of the currency. Similarly, if the imports are higher, the value of the currency falls. 

5. Status of the economy 

A country’s economy plays a major role in determining the exchange rate of its currency. When an economy is in recession or slowing down, the country’s central bank tends to reduce the rate at which it lends money to other banks and financial institutions in a bid to boost the economy. A drop in the central bank’s lending rate would increase the circulation of money in the economy, which would then increase the rate of inflation. And as we already saw earlier in this chapter, a high rate of inflation depreciates the value of a currency.   

6. Political scenario 

A country’s political stability also has the ability to influence the exchange rates of its currency. There’s nothing that traders and investors dislike more than uncertainty. A country with an unstable political scenario is less attractive for investors and is less likely to draw in foreign investment. This can end up decreasing the value of the currency. 

Other political events and decisions also tend to affect the currency rates of a country. An excellent example is the Brexit referendum, which caused the pound to decline steeply for a bit, and then brought in a lot of slumps and an overall decline compared with the pre-referendum rates. 

7. Market sentiment 

The public perception of a country’s currency also has an effect on the currency exchange rates. Generally, the currency market sentiment is powered by news reports and current happenings. If the currency market perceives a country’s currency in a positive light, its demand would see a sharp rise, which in turn would end up appreciating its value. 

Wrapping up

As a currency trader, it is important to keep an eye out for these factors since they can significantly influence the way you take up positions. Now that you’ve taken a good look at these factors, it’s time to delve into the events that you should know about before starting currency trading. We’ll talk about this in the next chapter.   

A quick recap

  • A consistent increase in the general prices of goods and services over a period of time is termed as inflation. As a consequence of an increase in the prices of goods, the purchasing power of a country’s currency falls. 
  • A high rate of inflation causes the value of a currency to drop and depreciate, whereas a low rate of inflation causes the value to appreciate.    
  • Balance of payments is essentially a statement that shows the difference between the inflow of money into a country and the outflow of money from the same country.
  • A deficit in the balance of payments means that the value of the country’s currency will depreciate.   
  • A country with high government debt is more likely to experience a decrease in the value of its currency when compared with a country with low government debt.  
  • The terms of trade is basically a ratio that indicates a country’s average export prices with respect to its average import prices. If the export prices of a country are more than its import prices, the value of its currency would increase since it would drive up the demand of the currency. 
  • A country’s economy and political stability also play a major role in determining the exchange rate of its currency.
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