The most important thing to remember about the factors that may influence currency exchange rates is that it is all about what would affect the supply and demand of a particular currency in the markets. For example, if there were an increased demand for US exports, it would cause the dollar to appreciate against other currencies, since there would be increased demand for the greenback to pay for US imports. On the other hand, uncertainty over the economy might cause traders to dump dollars, resulting in the dollar depreciating versus other currencies. Here are some of the major economic factors that have an impact on currency exchange rates and which every currency trader should be familiar with:
- Interest rates. When interest rates in a country are high relative to other countries, it becomes more attractive for investors to place money there, resulting in appreciation of the exchange rate as there is greater demand for the local currency. In fact, even anticipation among market traders that a country’s interest rates might go up can influence the direction of exchange rates.
- Balance of trade. When demand for a country’s goods increases, there is greater demand for its currency in order to pay for exports. This causes the exchange rate to appreciate. On the other hand, when a country imports more than it exports, the exchange rate depreciates as there is more demand for foreign currencies vis-à-vis the local one.
- Public debt. Generally, governments finance public sector projects by borrowing money, increasing the amount of public debt. This may cause currency exchange rates to depreciate as there is less demand for the local currency since investors are wary about investing in countries that have a heavy debt burden, due to concerns that they may not be able to service their debt.
- Political developments. Anything that affects the stability of a country is anathema to investors, resulting in the depreciation of exchange rates. For example, if there is a heavily contested election that may affect the peaceful transition of power, investors may choose to pull out their investments, resulting in less demand for the local currency as they exchange it for their home currencies.
- Economic developments. Since currency exchange rates are a reflection of a country’s economy, bad economic news can cause the exchange rate to depreciate while good news causes appreciation. For example, if it is reported that a country’s Gross Domestic Product will record positive growth, it can result in more investment, creating demand for the local currency and appreciating the exchange rate.
- Inflation rates. Inflation reflects not just changes in prices over time, but also the purchasing power of the currency or the amount of goods and services it can buy. When a country has a lower inflation rate, currency exchange rates appreciate as there is greater demand for goods. Inflation is also usually linked with interest rates as central banks usually move to lower high inflation by increasing interest rates in order to reduce the amount of currency circulating in the economy.
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