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Factors Affecting Exchange Rates

Exchange rates are moving all the time and sometimes they move unfavourably or unexpectedly. There isn’t one specific day, week, or month of the year that’s better for exchanging your currency. Factors affecting exchange rates include political stability, economic growth, notable events, and sometimes even extreme weather. 

If you’re managing money across multiple currencies, have overseas investments, or need to make international payments, it helps to stay up to date with currency movements and understand what causes them. In this article, we look at the factors affecting exchange rates, to help you understand how to monitor and analyse the exchange market to notice opportunities for investment. Let’s get started. 

What are exchange rates?

First, it’s important to understand what an exchange rate is. An exchange rate is the price of one country’s currency against another country’s currency, also known as a currency pair. For example, if the exchange rate from UK pounds to Euros is 1.19, then in exchange for £1 you would receive €1.19. Sometimes, a currency is described as having ‘appreciated.’ This means that the currency has increased in value in comparison to another country. 

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6 factors affecting exchange rates

Inflation rate differentials 

Typically, a country with a lower inflation rate will see an appreciation in the value of its currency compared to other countries with a higher inflation rate, as its purchasing power increases. When a country has low inflation, the prices of goods and services will increase at a slower rate. High inflation is usually accompanied by higher interest rates too. 

Interest rate differentials 

Inflation and interest rates are closely related, especially in terms of how they affect foreign exchange rates. When interest rates increase, a country’s currency will appreciate, providing higher rates to lenders. This attracts more overseas investment and creates a higher demand for the currency. For example, if UK interest rates rise relative to elsewhere, it will become more attractive to deposit money in the UK because you will get a better rate of return from saving in UK banks. 

If inflation is below its target level, a central bank may look to cut interest rates. Lower interest rates make it cheaper to borrow, and less rewarding to save, which encourages people to spend, pushing inflation levels higher. 

Political stability and economic conditions 

The foreign exchange rate is one of the most important factors through which a country’s relative level of economic health is determined. The economic and political conditions of a country will cause their currency’s value to fluctuate, which is why there is typically a higher demand for currencies from politically and economically stable countries. 

Government debt 

Government debt refers to the public debt or national debt owed by the central government. The value of government debt can influence the exchange rate. Public sector projects sometimes require large scale deficit financing which boosts the domestic economy. However, foreign investors are less likely to invest in countries with large public deficits and government debt because of fear of a debt default. If investors are concerned about a debt default, they will sell their bonds which will result in a fall in the value of the exchange rate.  

Balance of payments/ current account deficit 

A country’s current account is a record of a country’s international transactions with the rest of the world, reflecting the balance of trade and earnings on foreign investment. This includes all transactions that occur between resident and non-resident entities. If the value of imports is greater than the value of exports, this means there is a deficit in the current account. This causes depreciation and affects the exchange rate of its domestic currency. A lack of capital inflow to finance a current account deficit inevitably leads to depreciation in the currency.  

Recession 

Typically, during a recession, interest rates fall which has a knock-on effect on the value of a currency, decreasing its chances to acquire foreign capital and causing the currency to weaken in comparison to other countries. This isn’t always the case but does often happen. 

Speculation from investors 

Movements in currency exchange rates don’t always reflect economic activity. Sometimes, they are influenced by the sentiments of financial markets by investors, who will forecast changes in currency value. A government’s reserve of foreign currency is quite low compared to daily turnover in the market, which means speculators have quite significant power in exchange rate influence. Speculators will observe political events or changes in commodity prices to make their predictions and if they suspect that a currency will fall in value, they will sell it for a currency they believe will rise in value. 

Terms of trade 

Terms of trade are the ratio of export prices to import prices. If a country’s export prices rise at a greater rate than its import prices, then this results in higher revenue. With higher revenue, a country’s local currency will be in greater demand which in turn, increases the currency value. 

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