Factors That Influence Exchange Rates

Current Account Balances

This represents the receipts and payments of export and import activities between a country and other countries of the world, involving transactions relating to goods, services, dividend, and interest. When a country has current account surplus, it indicates receipt from export transactions is more than its payment for import, and in effect, its currency appreciates. But when a country’s import economic activities outweigh its export, this results in current account deficit. The excess demand for foreign currency will lead to the depreciation of the domestic currency.

Price Level Changes

Inflation is the general increase in the prices of goods and service leading to a fall in the purchasing power of money. When there is inflation, the value of money (the amount of goods the money can buy) will decline. Therefore, a country with a higher inflation rate relative to its counterparty will experience currency depreciation. A country currency will appreciate if its inflation rate is lower as compared with the inflation rate of the oversea trading partners. For this purpose, a country inflation rate is inversely related to its exchange rate.

Interest Rates

Interest rate is the compensation required by the suppliers of debt capital. It represents the rate of return to the bondholders on their investments. A country with a higher interest rate has the propensity to attract capital inflows (i.e., foreign investment) into the economy and increase the demand for the domestic currency. This, will in turn, lead to the currency appreciation. Usually, foreign investors will commit their limited scarce financial resources in a country where they can earn a higher return on their investments. However, it should be noted that positive correlation exists between interest rate and exchange rate. This means that if a country’s interest rate increases, its currency will appreciate, and if a country lowers its interest rate, its exchange rate decreases.

Economic Performance

A country with a strong economic performance arising from stable fiscal policies, low unemployment rates, and high GDP growth will experience increase in demand for its currency. These strong economic indicators have the tendency to enhance exchange rate of the country. Whereas a country with unstable or high political and economic risks will find it difficult to attract foreign investments.

Public Debt

This represents the total debt obligations owed by a country to its creditors. A country with a high level of sovereign debt consistent with its GDP, will find it difficult to attract foreign investment, leading to its currency depreciation. Whereas a country with a lower debt to GDP ratio can attract capital inflows, leading an increasing exchange rate.

Market Sentiment and Speculation

The investors’ or market participants’ perceptions about a country political and economic conditions can make exchange rate susceptible to market gyration in the short-term. Traders can speculate and adjust their positions to observe market reaction.