Currency exchange rates are one of the most important economic factors in determining a countries level of trade, and therefore, its level of economic health overall. Given the importance of these levels, it is not surprising that the foreign exchange market (FX) is one of the most actively traded, tracked, and analyzed markets on the planet. There are several factors that drive various FX levels, with each trying to place a relative value on the attractiveness of one currency versus the other. The following discussion examines the top factors, providing an overview and a basis for greater investigation.
As was underlined in the recent U.S. debt ceiling debacle, the impact of the overall debt level can play a role in FX as well. Countries that carry large quantities of debt are incented to let inflation run higher because it allows it to pay back these debts with cheaper currency (less purchasing power). Of course, since inflation has a negative impact on a currencyâ€™s exchange rate in the open market, high debt levels can cause an increase in inflation expectations, thus driving down FX rates as a result.
This factor is the most directly connected to the level of an exchange rate between one currency and another. The phenomena is easiest observed in terms of changing rates, so consider the case where the prevailing interest rates in Country A and increasing relative the interest rates in Country B. At higher rates, borrowers must pay a higher cost to receive capital and foreign investment becomes drawn to those rates. The increased demand for the currency of Country A, the basis for the loan, rises, and the exchange rate increases relative to Country B â€’ essentially, foreign investors bid up the currency so that they may then lend the money at higher, more attractive, rates. Because the prevailing interest rates in a given country are deeply impacted by interest rates, the actions of that countryâ€™s central bank play a central role as well.
The Current Account
This is the name given for the trade balance that exists in a given country between it and its trading partners â€’ essentially, it is a number that measures the value of the goods purchased domestically and manufactured abroad relative to goods manufactured domestically and purchased abroad (imports relative to exports). When this number is negative, it means that the country is spending more abroad than it is earning. As a net borrower, it must demand foreign currency in order to pay for the goods it is importing. As is the case with a countryâ€™s debt profile, when the country is carrying excess debt, it tends to weaken that currency relative to others. Of course, when the current account is positive the effect is reversed.
This factor is the countervailing force that acts with interest rates to keep things in balance; the inflation rate of a country tends to be highly correlated to interest rates â€’ re-enter the central bank. Inflation is most simply understood in this context as the rate at which the purchasing power of a given currency is destroyed. As goods appreciate in price, the value of the currency decreases because it takes more units to buy the same goods. When interest rates are high, foreign investors can earn a better return, but inflation tends to be higher as well. This means that the units of the currency they earn are worth less in absolute terms. An analysis of the overall effect on purchasing power yields some basis for deciding which is the best overall position.
Gross Domestic Product (GDP) and Political Stability
GDP is generally considered the best measure of a countryâ€™s overall economic performance and strength. When growth is present, the feeling is that the country presents a solid investment and that alone will attract foreign capital and drive up exchange rates. Conversely, when growth slows, the perception worsens and the country is less attractive. It is important to keep in mind that each of these metrics is considered on a relative basis, so even a negative reading can be positive in comparison. Also under this heading is overall political stability. GDP growth is one measure, but if one gets at all away from the largest six currencies, government stability itself can come into play.
As you can see, there are numerous factors that drive currency exchange rates. Â To be honest, we have only covered the surface on this topic. Â However, if you want to learn about the basic drivers, look for debt levels, interest rates, current account, inflation, and GDP compared to political stability. Â It’s important to know about these basic factors so you can better understand world events and the effects on world markets.
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About the Author: Jon the Saver is a personal finance writer at Free Money Wisdom. His mission is to help you succeed in your personal finance life. When Jon is not writing on personal finance, he spends time with his girlfriend, lifts iron at the gym, and plays Scrabble.