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6 Factors That Influence Exchange Rates

By Jason Van Bergen on July 23, 2010A A A

Filed Under: Exchange Rate Regime, Forex
Fundamentals, Inlation, !acroeconomics
Aside rom actors such as interest rates and inlation, the exchange rate is one
o the most im"ortant determinants o a country#s relati$e le$el o economic
health% Exchange rates "lay a $ital role in a country#s le$el o trade, &hich is
critical to most e$ery ree mar'et economy in the &orld% For this reason,
exchange rates are among the most &atched, analy(ed and go$ernmentally
mani"ulated economic measures% But exchange rates matter on a smaller scale
as &ell) they im"act the real return o an in$estor#s "ortolio% *ere &e loo' at
some o the ma+or orces ,ehind exchange rate mo$ements%
Beore &e loo' at these orces, &e should s'etch out ho& exchange rate
mo$ements aect a nation#s trading relationshi"s &ith other nations% A higher
currency ma'es a country#s ex"orts more ex"ensi$e and im"orts chea"er in
oreign mar'ets. a lo&er currency ma'es a country#s ex"orts chea"er and its
im"orts more ex"ensi$e in oreign mar'ets% A higher exchange rate can ,e
ex"ected to lo&er the country#s ,alance o trade, &hile a lo&er exchange rate
&ould increase it%
/eterminants o Exchange Rates
0umerous actors determine exchange rates, and all are related to the trading
relationshi" ,et&een t&o countries% Remem,er, exchange rates are relati$e,
and are ex"ressed as a com"arison o the currencies o t&o countries% 1he
ollo&ing are some o the "rinci"al determinants o the exchange rate ,et&een
t&o countries% 0ote that these actors are in no "articular order. li'e many
as"ects o economics, the relati$e im"ortance o these actors is su,+ect to
much de,ate%
1% /ierentials in Inlation
As a general rule, a country &ith a consistently lo&er inlation rate exhi,its a
rising currency $alue, as its "urchasing "o&er increases relati$e to other
currencies% /uring the last hal o the t&entieth century, the countries &ith lo&
inlation included Ja"an, 2ermany and 3&it(erland, &hile the 4%3% and 5anada
achie$ed lo& inlation only later% 1hose countries &ith higher inlation ty"ically
see de"reciation in their currency in relation to the currencies o their trading
"artners% 1his is also usually accom"anied ,y higher interest rates% 61o learn
more, see 5ost78ush Inlation Versus /emand78ull Inlation%9
Get a Risk-Free $50K Practice Account with
2% /ierentials in Interest Rates
Interest rates, inlation and exchange rates are all highly correlated% By

mani"ulating interest rates, central ,an's exert inluence o$er ,oth inlation
and exchange rates, and changing interest rates im"act inlation and currency
$alues% *igher interest rates oer lenders in an economy a higher return
relati$e to other countries% 1hereore, higher interest rates attract oreign
ca"ital and cause the exchange rate to rise% 1he im"act o higher interest rates
is mitigated, ho&e$er, i inlation in the country is much higher than in others,
or i additional actors ser$e to dri$e the currency do&n% 1he o""osite
relationshi" exists or decreasing interest rates 7 that is, lo&er interest rates
tend to decrease exchange rates% 6For urther reading, see :hat Is Fiscal
3% 5urrent7Account /eicits
1he current account is the ,alance o trade ,et&een a country and its trading
"artners, relecting all "ayments ,et&een countries or goods, ser$ices,
interest and di$idends% Adeicit in the current account sho&s the country is
s"ending more on oreign trade than it is earning, and that it is ,orro&ing
ca"ital rom oreign sources to ma'e u" the deicit% In other &ords, the country
re<uires more oreign currency than it recei$es through sales o ex"orts, and it
su""lies more o its o&n currency than oreigners demand or its "roducts% 1he
excess demand or oreign currency lo&ers the country#s exchange rate until
domestic goods and ser$ices are chea" enough or oreigners, and oreign
assets are too ex"ensi$e to generate sales or domestic interests% 6For more,
see 4nderstanding 1he 5urrent Account In 1he Balance - 8ayments%9
=% 8u,lic /e,t
5ountries &ill engage in large7scale deicit inancing to "ay or "u,lic sector
"ro+ects and go$ernmental unding% :hile such acti$ity stimulates the domestic
economy, nations &ith large "u,lic deicits and de,ts are less attracti$e to
oreign in$estors% 1he reason; A large de,t encourages inlation, and i
inlation is high, the de,t &ill ,e ser$iced and ultimately "aid o &ith chea"er
real dollars in the uture%
In the &orst case scenario, a go$ernment may "rint money to "ay "art o a
large de,t, ,ut increasing the money su""ly ine$ita,ly causes inlation%
!oreo$er, i a go$ernment is not a,le to ser$ice its deicit through domestic
means 6selling domestic ,onds, increasing the money su""ly9, then it must
increase the su""ly o securities or sale to oreigners, there,y lo&ering their
"rices% Finally, a large de,t may "ro$e &orrisome to oreigners i they ,elie$e
the country ris's deaulting on its o,ligations% Foreigners &ill ,e less &illing to
o&n securities denominated in that currency i the ris' o deault is great% For
this reason, the country#s de,t rating 6as determined ,y !oody#s or 3tandard >
8oor#s, or exam"le9 is a crucial determinant o its exchange rate%
?% 1erms o 1rade
A ratio com"aring ex"ort "rices to im"ort "rices, the terms o trade is related
to current accounts and the ,alance o "ayments% I the "rice o a country#s
ex"orts rises ,y a greater rate than that o its im"orts, its terms o trade ha$e
a$ora,ly im"ro$ed% Increasing terms o trade sho&s greater demand or the
country#s ex"orts% 1his, in turn, results in rising re$enues rom ex"orts, &hich
"ro$ides increased demand or the country#s currency 6and an increase in the
currency#s $alue9% I the "rice o ex"orts rises ,y a smaller rate than that o its
im"orts, the currency#s $alue &ill decrease in relation to its trading "artners%
@% 8olitical 3ta,ility and Economic 8erormance
Foreign in$estors ine$ita,ly see' out sta,le countries &ith strong economic
"erormance in &hich to in$est their ca"ital% A country &ith such "ositi$e
attri,utes &ill dra& in$estment unds a&ay rom other countries "ercei$ed to
ha$e more "olitical and economic ris'% 8olitical turmoil, or exam"le, can cause
a loss o conidence in a currency and a mo$ement o ca"ital to the currencies
o more sta,le countries%
1he exchange rate o the currency in &hich a "ortolio holds the ,ul' o its
in$estments determines that "ortolio#s real return% A declining exchange rate
o,$iously decreases the "urchasing "o&er o income and ca"ital gains deri$ed
rom any returns% !oreo$er, the exchange rate inluences other income actors
such as interest rates, inlation and e$en ca"ital gains rom domestic
securities% :hile exchange rates are determined ,y numerous com"lex actors
that oten lea$e e$en the most ex"erienced economists lummoxed, in$estors
should still ha$e some understanding o ho& currency $alues and exchange
rates "lay an im"ortant role in the rate o return on their in$estments%