A country’s exchange rate is vital to its relative level of economic prosperity. Exchange rates affect a nation’s level of trade and, as such, are monitored carefully across the globe by large financial bodies, as well as individual investors.
If you are wondering what affects the exchange rate of currency, the following article will look at factors such as differentials, public debt, and economic performance in further detail.
Differentials in Inflation
Normally, a country that has low inflation rates will see a growth in the value of its currency as purchasing power rises compared to other countries. Deprecation can often occur as a result of higher national inflation. This often comes with higher interest rates.
Differentials in Interest Rates
There is a strong correlation between interest rates, inflation, and exchange rates. Central banks can impact inflation and exchange rates by controlling interest rates. Lenders can get better returns as a result of higher interest rates. This draws more foreign investment and leads to a rise in exchange rates.
The effect of higher interest rates is lessened if inflation is much higher in a given country than in others. This is also true if the value of the currency drops.
Current Account Deficits
This is the balance of trade between a nation and its trading partners. It includes expenditures for goods and services, interest, and dividends.
Deficits in currency accounts suggest the country is overspending on foreign trade compared to its earnings. That means it is borrowing money from foreign bases to bridge the gap. If a country needs more foreign currency than it earns through export sales, it is supplying more of its currency than foreign investors request for its products.
This surplus demand for foreign currency leads to lower exchange rates until the goods and services of a country are affordable enough to attract foreign investment.
Public Debt
Government funding exists to stimulate the economy but in countries that have a lot of public debt, foreign investment is less likely. Large amounts of debt often lead to inflation which puts off foreign investors.
On occasion, the government of a country in debt may print more money to compensate. This understandably leads to inflation. Large debt also increases the risk of a country defaulting on obligations which too can put off foreign investment. This is part of the reason why a country’s debt rating is vital to its exchange rate.
Terms of Trade
Rising export prices can lead to favourable terms of trade. If the cost of exports rises faster than its cost of imports, its terms of trade become more appealing.
The higher the terms of trade, the more demand there is for a country’s exports. This directly leads to an increase in export sales which lifts demand for the country’s currency and boosts the value of it. The opposite is true if the cost of exports goes up by a smaller rate than its imports.
Strong Economic Performance
Foreign investors are after stability in their investments. Countries that exhibit strong economic performance are more likely to draw interest over less stable and risky countries economically speaking.
Political upheaval is just one factor that could lead to a loss of belief in a country’s stability and cause a shift of moving investments over to countries that are perceived to be less volatile.
The Bottom Line
A currency’s exchange rate is vital to an investor’s return. A weakening exchange rate leads to decreased purchasing power. In addition, the exchange rate impacts many other income factors like interest rates, capital gains, and inflation. With Cashero, you can protect your money from currency fluctuations by converting your local currency to one of the three generally stronger currencies, USD, GBP and EUR.
Exchange rates are influenced by several complex elements that can be difficult to comprehend by professionals. Nevertheless, it is important that investors have a basic understanding of how exchange rates and currency value affects the rate of your return on investment.
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