The exchange rate is one of the most important determinants of a country’s relative level of economic health. The movement of the exchange rate has a significant effect on a nation’s trading relationship with other nations. A higher exchange rate makes a country’s export products more expensive and its imports cheaper in foreign markets. Conversely, a lower currency means cheaper export products and more expensive imports in foreign markets.
So what are the major factors that influence exchange rates?
Differentials in Inflation. A country with a consistently lower inflation rate generally exhibits a rising currency value. This means that a country’s purchasing power increases relative to other currencies. (Take note that exchange rates are relative and are expressed in comparison to the currencies of other countries.)
Differentials in Interest Rates. Interest rates, inflation, and exchange rates are closely linked together. When central banks manipulate interest rates, both inflation and exchange rates are also influenced. Higher interest rates allow lenders to gain higher returns. Notably, higher interest rates also attract foreign capital that causes exchange rates to rise.
Current-Account Deficits. The ‘current account’ reflects all trade payments between countries for goods, services, interest, and dividends. So, a deficit in the current account means that a country is spending more on foreign trade than what it’s earning. In other words, the excess demand for foreign currency pulls down a country’s exchange rate until domestic goods and services are cheap enough for foreigners and foreign assets are too expensive to generate domestic returns. The difference between a country’s imports and exports is unhealthy; the balance of trade is disrupted.
Public Debt. There are instances when a country needs to borrow money to pay for public sector projects and, also, for their own government’s funding. While such move stimulates the domestic economy, a large debt encourages inflation. This leads back to the discussion on the differentials in inflation. High inflation = low currency = low purchasing power.
Terms of Trade. ‘Terms of trade’ refers to the ratio comparing export and import prices. An increasing terms of trade means a greater demand for the countries exports. This translates to high revenues from exports and an increased demand for the country’s currency.
Political Stability and Economic Performance. A stable country is more likely to exhibit a strong economic performance. Stable countries are also the same countries that attract foreign investments. So as more investments come in, a country’s capital rises. In effect, this ensures a more stable currency.
Why bother to know these things? Because exchange rates matter on a smaller scale as well, i.e. they impact the real return on an investor’s portfolio; because exchange rates also affect you’re spending, as well the prices of your country’s goods and services, and even employment rates.
Source: Investopedia
