A country’s exchange rate is one of the most important factors that determine the health of its economy. Exchange rates, along with interest rates and inflation, play a major role in a country’s economic performance and are vital to almost every free market in the world.
So, in addition to being one of the most watched and analyzed financial indicators, the exchange rate is also one of the most regulated by governments. But the exchange rate also has a small impact: It affects the returns on investors’ portfolios. Let’s look at five key factors that affect exchange rates.
Key Learnings
- Along with factors such as interest rates and inflation, exchange rates are one of the most important factors determining the health of a country.
- A positive exchange rate causes a country’s goods to be cheaper in its domestic market and its exports to be more expensive in foreign markets.
- Exchange rates are always relative and are expressed by comparing the currencies of two countries.
- Inflation, Interest Rate, Current Account Deficit, Trade Balance and Public Debt
An Overview of Currency Exchange
Currency pairs fluctuate constantly, causing their value to increase or decrease relative to other currencies. When a country’s currency appreciates, it makes domestic products cheaper for its citizens and exports more expensive for consumers in foreign markets. Products are cheaper for consumers in foreign markets.
An increase in the exchange rate can also contribute to a country’s economic balance. In other words, the country’s export profit decreases and import costs increase. A lower exchange rate is expected to improve the trade balance.
Main Influences on Exchange Rates
The rise and fall of a country’s exchange rate reflects many factors. All of these factors are related to the country’s economic relationship with its major investors. The exchange rate is relative and is expressed by comparing the currencies of two countries. Here are some important points (in no particular order). The relative importance of these events is still debatable.
Differences in Inflation Rates
A country with a lower exchange rate will generally be worth more in relation to its own currency, as its strength in other currencies increases. Countries with low inflation in the second half of the 20th century include Japan, Germany, and Switzerland, while the countries with the most recent low inflation were the United States and Canada.
In countries with high inflation, profits are often lower than those of their trading partners. This often comes with higher interest rates.
Interest Rate Fluctuations
Interest rates, inflation and exchange rates are closely related. Central banks can influence inflation and exchange rates by controlling interest rates, and changes in interest rates can also influence inflation and the prices of currencies. return. High interest rates attract foreign capital and make exchange rates more attractive.
However, if a country’s inflation rate is higher than other countries’, or if other factors are causing the currency to lose value, increasing interest rates will have less of an impact. When interest rates fall, the opposite relationship occurs. In other words, lower interest rates will lower the exchange rate.
Current Account Deficits
The current account is the balance of foreign trade between a country and its trading partners, showing all payments made by the country for goods, services, interest, and money. The demand for foreign exchange is greater than the income from sales, and the supply of its own currency is greater than the income from sales.
Until domestic goods and services become cheap enough for foreigners, or foreign assets become too expensive to sell for domestic consumption, the demand for foreign currency remains below the country’s exchange rate.
Public Sector Debt
The country will run a fiscal deficit to finance public projects and government finances. While these activities stimulate domestic economies, countries with large populations and high debt levels become less attractive to foreign investors. If the debt on electricity bills is high and inflation is high, the debt will be paid off with cheaper money in the future.
In the worst case scenario, the government will print money to pay off some of its large debts, but the increase in the money supply will lead to more inflation. Also, if the government cannot finance its deficit through domestic spending (selling domestic bonds or raising additional funds), then it must increase its output and sell it to foreigners, thereby lowering their prices. Foreign investors who believe the country is at risk of bankruptcy will be concerned about the large debts. Foreigners will not be interested in holding stocks in these currencies.
Exchange Terms in Trade
The terms of trade are the ratio of export prices to import prices and are related to the current account and the balance of payments. 8 Improvements in the terms of trade indicate an increase in demand for a country’s exports. This leads to an increase in export revenues, which in turn increases the demand for the country’s currency (and the value of the currency). As the value of participants’ trade earnings decreases, the value of benefits will also decrease.
Currency Fluctuations and Their Effect on Investment
Foreign investors and foreign companies are looking for countries with strong and stable economies as investment targets. Countries with these characteristics will attract investment away from countries perceived as more politically and financially risky.
Understanding Exchange Rates
An exchange rate is the ratio of the value of one country’s currency to the value of another country’s currency. These results are constantly changing. A strong Polish zloty means that Poland’s currency (and its exports) is worth more than the US dollar or British pound.
How Currency Rates Affect Everyday People
For consumers, lower prices mean that imported goods are sold at higher prices. The higher the profit, the cheaper the goods can be purchased. This has negative consequences for many countries because goods such as electronics and cars are mostly exported. First, the dollars (or yen or yuan) they hold will be worth less than before. Second, changes in interest rates can affect the profits of companies invested in.
Is a Strong Currency Beneficial or Detrimental?
It is. For example, if you are traveling abroad, a stronger exchange rate means you can exchange your money for more pounds or euros. The American tourism industry could suffer as higher energy prices make it more expensive to travel to the United States. This could mean more profit for American companies or lead foreign consumers to choose cheaper local products.
Final Thoughts
Exchange rates can have a real impact on investors’ portfolios. The exchange rate of the currency in which a security stores most of its resources determines the yield on that security. A falling exchange rate reduces the receipt of income and capital gains from remittances.
Exchange rates also affect other sources of income, such as interest rates, inflation, and even capital gains from domestic securities. Although exchange rates are determined by complex factors that can be confusing for investors, investors still have to pay for the exchange rate because they have a significant responsibility to pay it back.
