Foreign Currency Exchange Rates: Have you ever wondered how foreign currency exchange rates are established and what causes fluctuations in foreign exchange rates? Foreign currency exchange rates are one of the leading factors in any country's economy and hence are of immense importance for government, financial institutions and investors. Fluctuations in exchange rates have significant …
Have you ever wondered how foreign currency exchange rates are established and what causes fluctuations in foreign exchange rates? Foreign currency exchange rates are one of the leading factors in any country’s economy and hence are of immense importance for government, financial institutions and investors. Fluctuations in exchange rates have significant implications for countries and various stakeholders within their economies. These fluctuations in the exchange rate, whether appreciations or depreciations, impact trade, investment, government finances, inflation, and the overall economic stability of a country.
One thing which dictates foreign currency exchange rates is the supply and demand of that currency. For example, greater demand for British goods would cause an appreciation of the value of the Pound. There are various other factors that influence exchange rates, such as interest rate, inflation, public debt etc., which will be discussed in detail in this blog.
Interest rates and exchange rates are strongly correlated; government and central banks often increase interest rates to attract investors seeking higher returns on their investments to modulate inflation in the country. The higher the interest rate, the more it will attract foreign capital, increasing the foreign currency exchange rate, whereas lower interest rates result in the depreciation of exchange rates.
Inflation refers to the rate at which the cost of goods and services increases over time and directly impacts a country’s current and future economic condition. Countries with lower inflation rates exhibit an increase in currency value, whereas countries with higher inflation see depreciation in the currency. This is because inflation impacts a country’s purchasing powers; hence currency rates changes. Central banks often implement monetary policies to manage inflation, which indirectly affects foreign currency exchange rates.
The strength of any currency is also established by the political stability of the country. Foreign investors are attracted more towards countries with political stability and favourable political conditions, leading to the appreciation of the currency rate. Political uncertainty, such as leadership changes, geopolitical tensions and elections, cause foreign currency exchange rate fluctuations. Political turmoil can cause a loss of confidence in a country’s currency, causing the currency to depreciate.
A country’s public debt also attributes to the appreciation or depreciation of any country’s currency. Governments sometimes require large-scale deficit financing, but when it comes to foreign investors, they are very less likely to invest in a country with huge public debt. Paying off debt can also result in inflation hence depreciation of the currency.
A country’s economic condition is another factor which determines foreign currency exchange rates. Foreign investors look for stable economic conditions to invest their capital. A stronger economy attracts more foreign investment, which lowers the inflation rate increasing the exchange rate. In contrast, recession causes depreciation in the foreign currency exchange rate.
The country’s current account is closely related to the trade balance and influences foreign currency exchange rates. The positive current account, where there is a demand for the country’s currency, causes appreciation in the exchange rates. Conversely, a higher current account deficit will weaken the currency, causing depreciation.
Another determinant of the exchange rate is market speculation and investors’ sentiments towards the particular currency. The sentiment of market participants can be influenced by economic indicators such as interest rates, inflation, monetary policy, trade balance, current account, GDP, political stability and geopolitical events. Other factors that impact investors’ sentiments are news events, and market trends, leading to sudden and significant movements in exchange rates.
Foreign currency exchange rates significantly influence global economic growth, international trade, tourism, and foreign investments. They determine the value of one currency relative to another, and it is crucial to comprehend the key factors influencing currency exchange rates for individuals and businesses engaged in international transactions. Interest rates, economic performance, political stability, inflation rates, current account balances, and market sentiment all contribute to the fluctuations of exchange rates. Keeping an eye on these variables can help businesses and individuals to predict market movement and mitigate risks associated with currency volatility.
