Exchange rates play a major role in a country's level of trade, which is critical to almost every free market economy in the world. For this fact, exchange rates are among the most reviewed, analyzed and manipulated governmentally. Although exchange rates matter on a lower scale but they impact the real return of an investor's portfolio. Below are some of the major forces behind exchange rate movements.
DETERMINANTS OF EXCHANGE RATES
Different factors regulate exchange rates, and all are related to the trading relationship between two countries. Exchange rates are proportionate, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries.
1. DIFFERENTIALS IN INTEREST RATES
Interest rates, inflation and exchange rates are all eminently correlated. Central banks exercise influence over both inflation and exchange rates, and changing interest rates affects inflation and currency values. Higher interest rates bids lenders in an economy. Therefore, greater interest rates attract foreign capital and cause the exchange rate to increase. The effect of higher interest rates is reduced; however, if inflation in the country is higher than in others, the opposite relationship exists for decreasing interest rates. That is, minimum interest rates tend to reduces exchange rates.
2. CURRENT-ACCOUNT DEFICITS
Thecurrent account harmonizes trade among a country and its trading partners. This determines all payments among countries for goods, services, interest and dividends. A shortfall in the current account shows the country is spending more on foreign trade than it is gaining, and that it is borrowing capital from foreign sources to make up the deficit.
Due to the fact that foreign currency is in high demand, the surplus demand for decreases the country's exchange rate until goods and services are moderate enough for foreigners and foreign assets are costly to generate sales for domestic interests.
3. TERMS OF TRADE
The terms of trade are similar to current accounts and the balance of payments. If the amountof a country's exports boosts by a greater rate than that of its imports, its terms of trade have favorably improved. If the term of trade is increased, it means higher demands for the country’s exportation. If the price of exports increases by a little rate than that of its imports, the currency's value will decrease in relation to its trading partners.
4. POLITICAL STABILITY AND ECONOMIC PERFORMANCE
Foreign investors surely seek out countries that are stable with strong economicperformance in which to invest their capital. A country with such favorable attributes will attract investment funds away from other countries recognized to have more political and economic risk. Political instability, for instance, can cause a lack of assurance in a currency and a movement of capital to the currencies of more stable countries.
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.