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What Factors Affect Exchange Rates?

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40 years ago, only a select group of investors could participate in the foreign exchange trade – investment bankers that wanted to grow wealth for large client accounts, and multinational corporations that needed international currencies to pay for foreign goods and services. Back then, retail traders were few and far between.

Today, the number of forex traders in the United States exceeds two million. Thanks to the internet, the average consumer now has access to the once-exclusive foreign exchange trade. To trade forex, today’s traders only need to access the internet, some reputable trading software, and create an account at a forex brokerage website.

But becoming a successful forex trader is not easy. Successful forex traders need to be patient, do their due diligence, be shrewd enough to identify the best trading strategies, and disciplined enough to stop themselves from making emotional investment decisions. At the very least, they will need a good understanding of what gives currencies their value, and which factors affect their price. To help, we’ve outlined a short list of factors that play a major role in shifting currency exchange rates.

Inflation refers to the simultaneous rise of prices and fall of a currency’s purchasing power. Inflation will affect exchange rates if a currency’s purchasing power falls in comparison to other currencies. Let’s say it takes a thousand units of one currency A to buy a single chair, and one hundred units of currency B to buy the same chair. Because currency B has more purchasing power, it would be considered more valuable than currency A.

Inflation is one of the biggest factors contributing to the value of a currency. Many other factors, such as economic health, interest rates, and national debt, contribute to the value of a currency solely because they play a hand in inflation.

 

Having a high national debt can lead to inflation, and thus lower a currency’s value. A feature on how inflation affects interest rates by AskMoney explains that having a high national debt means that governments need to find new ways to make payments. Some governments choose to source funds from corporations and thus raise corporate taxes. To account for their increased tax expenses, corporations, in turn, raise their prices, which leads to inflation. Because the increase in prices means a reduction in purchasing power, the country’s currency depreciates.

 

According to a definition from This is Business, the balance of trade refers to the ratio between a country’s exports and imports. If the number of goods a country sells to other countries exceeds the number of goods that a country buys from other countries, then that means more foreign currency flows into the country than out of it. Bigger cash reserves let the country invest in economic development, which boosts its currency’s value.

 

When the economy performs well, citizens can easily pay their taxes, allowing governments to invest in positive developments. Good economic performance attracts foreign investors, who can increase a country’s cash reserves and make the value of its currency stronger.

 

Political instability often leads to poor economic performance. And when a country’s economy performs poorly, it drives foreign investors away, which devalues that country’s currency.

Once you understand the basics of currency values and which factors affect them, you can then turn to advanced strategies for assessing forex trade prices. Our guide ‘Simple Profitable Forex Trading Strategy’ can help you figure out how to analyze fundamentals, invest in breakouts, and trade according to trends.

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