In addition to inflation and interest rates, currency exchange rates are often used to measure the level of a country’s economy.
Currency exchange rates play an important role in trade between countries, because most countries in the world are currently involved in free market economic activities.
For investment companies and foreign investors, currency exchange rates will have an impact on returns and investment portfolios.
Factors Influencing Currency Exchange Rates
The exchange rate of a country’s currency is relative, and is expressed in comparison with other countries’ currencies. Of course, changes in currency exchange rates will affect trading activities in both countries. A stronger exchange rate will make one country’s exports more expensive, and imports from other countries, and vice versa. The following are 6 factors that can affect the movement of the currency exchange rates of the two countries:
The difference in inflation rates between the two countries
Countries with consistently low inflation rates will have a stronger exchange rate than countries with higher inflation. Purchasing power (purchasing power) currency is relatively greater than that of other countries. At the end of the 20th century, the countries with the lowest inflation rates were Japan, Germany and Switzerland, while the United States and Canada followed later. Currency exchange rates in countries with high inflation will be lower than those in trading partner countries.
The difference in interest rates between the two countries
Interest rates, inflation and exchange rates are closely related. By changing interest rates, a country’s central bank can influence inflation and currency exchange rates. Higher interest rates will increase the demand for that country’s currency.
Domestic and foreign investors will be attracted by the bigger returns. However, if inflation rises again, investors will be left alone until the central bank raises interest rates again. Conversely, if the central bank cuts interest rates, it will tend to weaken the country’s currency exchange rate.
Balance of trade
The trade balance between the two countries contains all payments for the sale and purchase of goods and services. A country’s trade balance is called a deficit if the country pays more to trading partner countries than payments received from trading partner countries.
In this case, the country needs more trading partner country currency, which results in a weakening of the country’s currency exchange rate against partner countries. The opposite situation is called a surplus, in which the country’s currency exchange rate strengthens against trading partner countries.
The balance of the state’s domestic budget is also used to finance projects of public interest and the government. If the budget is in deficit, the public debt will swell. Higher public debt will lead to higher inflation. Budget deficits can be covered by selling government bonds or printing money.
The situation could get worse if the large debt causes the country to default so that its debt rating drops. Obviously, high public debt will tend to weaken the country’s currency exchange rate.
The ratio of export prices and import prices
If export prices rise faster than import prices, a country’s currency exchange rate tends to strengthen. The country’s demand for goods and services is increasing, which means that the demand for its currency will also increase. The reverse situation is that import prices rise faster than export prices.
Political and economic stability
Investors will definitely look for countries with good economic performance and stable political conditions. Countries with unstable political conditions tend to be at high risk as a place to invest. The political situation will have an impact on economic performance and investor confidence, which will ultimately affect the country’s currency exchange rate.