Other than inflation and interest rates, a country's currency exchange rate is among the most significant signs of that country's relative economic strength. Rates of exchange perform a significant role in a country's trade levels—levels that are crucial to just about every free market system in the entire world. This is why economic experts keep a close eye on exchange rates. However, exchange rates are important for another reason as well—they have a strong impact on the actual returns of investors’ portfolios.

This article outlines some of the most important forces that influence exchange rates.

It is important to understand how relative currency values influence the trading relationships between countries. If a country has a currency that is greater in relative strength than that of its trading partners, that country's exports will cost more, and its imports will cost less. Conversely, exports are cheaper with a currency that has less value, while imports end up costing more. Exchange rates that are higher reduce a nation's balance of trade, while lower exchange rates increase that balance.

There are a number of factors that influence rates of exchange, and they all have connections to the trading relationship that exists between the two countries in question. Exchange rates are not absolute; they vary as the trading parties change. Understanding how each of these factors affects exchange rates is important if forex investors wish to be savvy.

If a country´s currency is greater in strength than that of another country, that country's exports will cost more, and its imports will cost less.

Interest-rate differentials

There is a close connection among exchange rates, inflation and interest rates. Central banks influence exchange rates every time they manipulate the rate of interest. The lenders in an economy that has higher interest rates (than those in another country) receive a higher rate of return than do lenders in other countries. This means that foreign capital is going to head into a country that offers higher interest rates, meaning that the exchange rate will go up. However, if inflation is significantly higher in that country than it is in other countries, interest rates will not influence the exchange rate as much. For a similar reason, lower rates of interest generally lead to lower exchange rates as well.

Investors tend to borrow in countries that have low interest rates and invest in countries that have high interest rates.

Inflation differentials

If one country generally features lower inflation, its currency will tend to go up over time, because its purchasing power is stronger than that of other currencies. Between World War II and 2000, the countries with the lowest inflation were Japan, Switzerland and Germany, while inflation in Canada and the United States only went down later. Higher inflation generally leads to depreciation for a currency, at least in relation to the currencies of that country's main trading partners.
Low inflation is seen as a sign of a healthy economy that is likely to attract investors, and the economy’s currency will generally appreciate (rise).

Current account deficits

The trade balance between a particular nation and its various trading partners is known as the current account. Current accounts reflect all of the payments that countries exchange for services, goods, interest and dividends. If a country features a deficit in its current account, that country is spending more capital on foreign commerce than it brings in, and it has to bring in capital from foreign funding sources to cover the deficit. This means that 1) the country needs more of the foreign currency that it gets through selling exports, and 2) it provides more currency than foreigners actually need for its products. The elevated level of demand for a foreign currency reduces the exchange rate for that country, and it has to supply larger amounts of its own currency.
The current account reflects the payments that countries exchange. If a country features a deficit in its current account, more foreign currency is needed, reducing the exchange rate for that country.

The public debt

Frequently, countries take on wide-ranging deficit financing on a large scale to fund public sector projects and government funding. This sort of activity boosts the domestic economy, but countries with significant public deficits are not as attractive to outside investors. Large debts encourage inflation, which is generally seen as a negative indicator, having a negative impact on a country’s currency exchange rate.

Countries that have significant public deficits are not as attractive to outside investors.

Terms of the trade

Terms of the trade is a ratio that compares import prices to export prices within a particular country; it also has links to the balance of payments and current accounts. If a country's export value increases by a more significant rate than that its imports, the terms of trade have undergone significant improvement. Boosting the terms of trade leads to a larger demand of the exports of another country.

Terms of trade compares import prices to export prices within a particular country. If terms of trade increase, this means that export demand has gone up.

Fiscal Policy

A government can increase or decrease the level of spending in its economy by using its own funds to achieve its economic goals.

In a recession, the government is likely to spend more money and fewer taxes, creating a larger cash flow for the country’s population. This is known as easing the fiscal policy and can serve to stimulate economic growth. Easing fiscal policy generally occurs when government financing requirements are greater than those of the previous year.

Alternatively, when there is strong growth period, the government is likely to spend more and tax less, leaving more money in peoples’ pockets to spend, thus stimulating economic growth. This is known as tightening the fiscal policy and can serve to restrain economic growth.

Easing a country’s fiscal policy can serve to stimulate economic growth.

Economic performance and political stability

Forex investors almost always look for stable nations that have strong indicators in their economies. If this is not in place within a particular country, it may be time to consider a different trade. Political instability can generate an overall confidence drop in a country, inspiring capital to quickly flee from that country's currency to stronger places.

A currency's exchange rate (in which a specific portfolio holds most of its investments) determines the real return that the portfolio can bring. When exchange rates decline, income loses purchasing power. Also, the currency exchange rate influences inflation, interest rates, and capital gains that apply to the economy. It is important that investors understand the effects that exchange rates have on economies.

Political events and conditions can have a strong effect on a country’s currency and market. Most traders and investors will look for stable nations with strong indicators.

Economic Releases

Traders and investors should be consistently monitoring daily economic releases. Not all economic statistics or news announcements have the same effect or importance.

There are three main economic indicators:

A Leading Indicator: This indicator is likely to tell you what will happen in the future. Weekly jobless claims, consumer expectation and money supply are considered leading indicators. 

A Lagging Indicator: This indicator is likely to tell you what has happened in the past. Average unemployment, change in interest rates, and change in labor costs are considered lagging indicators. 

A Co-incident Indicator: This indicator is likely to tell you what is happening now. Nonfarm payroll, industrial production, and retail sales are considered co-incident indicators.

Tradingfo´s economic calendar is the easiest way to keep track of upcoming announcements and their possible effects.

Bottom Line

Otherwise known as forex or the currency market, foreign exchange is the biggest market available for traders, offering high liquidity, competitive spreads and a 24h market. Forex was original created to cater supply and demand for currencies by governments and financial institutions. Little has changed from then except for its growth in size and accessibility.

 

Summary:

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Other than inflation and interest rates, a country's exchange rate is among the most significant signs of that country's economic strength.

 

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If a country´s currency is greater in strength than that of another country, that country's exports will cost more, and its imports will cost less.

 

P

Investors tend to borrow in countries that have low interest rates and invest in countries that have high interest rates. 

 

P
P

Low inflation is seen as a sign of a healthy economy that is likely to attract investors, and the economy’s currency will generally appreciate (rise).

 

P

The current account reflects the payments that countries exchange. If a country features a deficit in its current account, more foreign currency is needed, reducing the exchange rate for that country.

 

P

Countries that have significant public deficits are not as attractive to outside investors

 

P

Terms of trade compares import prices to export prices within a particular country. If terms of trade increase, this means that export demand has gone up.

 

P

Easing a country’s fiscal policy can serve to stimulate economic growth.

 

P

Political events and conditions can have a strong effect on a country’s currency and market. Most traders and investors will look for stable nations with strong indicators.

 

P

Tradingfo´s economic calendar is the easiest way to keep track of upcoming announcements and their possible effects.

 

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