The Foreign Exchange rate (better known as the Forex rate) is one of the most important means through which a country’s relative level of economic health is determined. A country’s foreign exchange rate provides a window to its economic stability, which is why it is constantly watched and analyzed. If you are thinking of sending or receiving money from overseas, you need to keep a keen eye on the currency exchange rates.
The exchange rate is defined as “the rate at which one country’s currency may be converted into another.” It may fluctuate daily with the changing market forces of supply and demand of currencies from one country to another. For these reasons; when sending or receiving money internationally, it is important to understand what determines exchange rates.
This article examines some of the leading factors that influence the variations and fluctuations in exchange rates and explains the reasons behind their volatility, helping you learn the factors that influence your Forex trades (and also let you know the best times to send money abroad!).
1. Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate than another’s will see an appreciation in the value of its currency. The prices of goods and services increase at a slower rate where the inflation is low. A country with a consistently lower inflation rate exhibits a rising currency value while a country with higher inflation typically sees depreciation in its currency and is usually accompanied by higher interest rates
2. Interest Rates
Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates, and inflation are all correlated. Increases in interest rates cause a country’s currency to appreciate because higher interest rates provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in exchange rates
3. Country’s Current Account / Balance of Payments
A country’s current account reflects balance of trade and earnings on foreign investment. It consists of total number of transactions including its exports, imports, debt, etc. A deficit in current account due to spending more of its currency on importing products than it is earning through sale of exports causes depreciation. Balance of payments fluctuates exchange rate of its domestic currency.
4. Government Debt
Government debt is public debt or national debt owned by the central government. A country with government debt is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their bonds in the open market if the market predicts government debt within a certain country. As a result, a decrease in the value of its exchange rate will follow.