Have you ever thought how foreign exchange rates are determined and how it is concluded that today a dollar will be equal to 0.6 EUR. Forex rates are defined as the amount of your currency required to buy a foreign currency. It weightily indicates the relative level of country’s economic health. Level of trade of a country is vastly affected by the currency exchange rate. Hence they are the most followed, analyzed and often manipulated by government. Thus many factors act as foreign exchange rate determinants.
To better understand the 5 determinants of foreign exchange rates let us see how trade associations between countries are affected due to changes in the exchange rates. Higher currency value will make exports expensive and imports cheaper for a country; contradict to this lower currency value will make imports expensive and exports cheaper for a country. Balance of trade is likely to be disturbed because of high exchange rate and will increase with low Forex rates. Thus numerous factors related to trade relations between two nations influence currency exchange rate.
We can list 5 determinants of foreign exchange rates as below:
Country with a lower inflation rate has greater purchasing power against other currencies and so displays rising currency value. Higher rate of inflation obviously lowers currency value.
Changing Interest Rates
Inflation, interest rates and exchange rates are closely related to each other. Central banks forge interest rates to influence exchange rates and inflation which directly affect the inflation and forex rates. Let me explain how it works? Higher interest rates which are sure to benefit investors attract more foreign investors. This results in the increase in foreign capital with the country and increased foreign exchange rates. There are chances that the effect of increased interest rates is reduced due to other factors. Low interest rates will create an opposite scenario.
Current Account Paucity
For a country, its current account includes details of trade transactions with other nations and reflects payments made and received for dividends, interests, goods and services. Deficit balance in the account indicates that the country spends more than it earns on foreign trade meaning it is increasing foreign debt to meet the difference. In simple words this deficit would mean that the country needs more foreign currency than it receives from different sources and over supply’s own currency. Increased demand results in lowered foreign exchange rates for the country.
Nations incur large public debts to pay for government funding and public welfare projects. Though domestic economy seems to be stimulated with this, international economy suffers. Thus they attract less foreign investors as large public debt bolsters inflation and high inflation means debt will be paid off with cheap real dollars. It is also possible that the government prints more currency to pay some part of the debt. This will further increase supply of money in the market which will ultimately result in inflation. Economic conditions which make the country less attractive to foreign investors ultimately affect its foreign exchange rates.
Terms of Trade
The ratio between the import and export prices of a country is referred to as terms of trade and is combined with current accounting and outstanding payments. Terms of trade affect the foreign exchange rate and are considered to be favorable if price of exports rises than that of imports. Improved terms of trade will improve foreign exchange rates.