The Economic health of a country is determined or valued by the Exchange Rate of the imported goods. The exchange rate is a key indicator of a country’s economic wealth. It has a significant impact on a country’s status related to economic standards.
Exchange rate influences not only the government but also big financial institutions and small investors. That’s why it is handled and analysed very carefully in every country. Currency Supply and demand are important measures to analyse the exchange rate. These supply and demand are affected by various factors like economic, political, and social growth.
If a country holds a weaker currency value, then the price it pays for imported products will increase. Whereas, A stronger currency value of a country may reduce the prices of imported goods.
A higher exchange rate can baffle a country’s balance of trade, while a lower exchange rate can improve it. Exchange rates are crucially affected by interest rates.
Let’s have a read over the important factors affecting exchange rates briefly in the upcoming passages.
Factors Affecting Exchange Rate
1. Economic Factors
Economic performance has a huge impact on the exchange rate. Economic factors are highly influenced by interest rates, inflation rates, and economic growth.
Interest Rates: In a country, Governments and Central Banks play a vital role in managing the country’s economic standard, thus they have the authority to influence exchange rates by increasing interest rates. When a country has a high interest rate, creditors or money lenders have an opportunity to earn more.
This fascinates foreign capital to earn at higher rates. Thus, the country’s foreign exchange rate rises, making its currency stronger. Interest rates correspond to inflation as well as exchange rates. High interest rates lead to higher costs of borrowing. There is a basic relation between inflation, interest rates, and exchange rates.
Inflation Rates: Inflation is the rate at which prices for goods and services rise in an economy over a given period of time. Generally, when a country has a lower inflation rate constantly, it exhibits a rising currency value, since its purchasing power increases relative to other currencies with which it is compared. Higher inflation rates lead to the currency’s decline in value, losing out on purchasing power and value against other currencies.
Economic Growth: Economic growth is the indicator of a well-developed country. If a country is growing well economically, then various investors and foreigners will try to invest there. There occurs an exchange of currencies which eventually leads to economic growth
2. Political Factors
Political Stability, Government Policies, and Trade Policies are the important directing mechanisms to affect political factors. Political stability can affect the strength of a currency in a country. Foreign investors are more fascinated to invest in a country where there is less tendency for political disturbance.
Drawing investments from foreign countries can lead to an appreciation of the domestic value or currency. Unstable conditions in political events can generally lead to less foreign investment which gradually decreases the rate of domestic currency.
Market Sentiment and Speculation: Investor Sentiment and Speculation can significantly affect the exchange rate. Investor sentiment is highly affected by factors like macroeconomic indicators, geopolitical incidents, and significant market trends. The COT report can assess market sentiment accurately through news and social media. Market sentiment, in other words, risk appetite has a crucial role in affecting the exchange rate.
Speculation can cause quick and uncertain fluctuations in the exchange rate. In a country, sometimes governments and central banks interfere to normalize or stabilize their currencies in case of extreme speculation.
3. External Factors
Global Events and Market Liquidity are the external factors that affect the exchange rate. Unpredictable turmoil and sudden changes can influence global events and market liquidity. An increase in market liquidity led to currency appreciation.
An increase in the interest rate may affect the value of currency. Market liquidity is an important factor for all financial markets. The foreign exchange market is particular in guaranteeing computer-assisted trading including bonds, and stocks.
Bottomline
When a portfolio holds the exchange rate of the currency as its investment, it is the portfolio that decides its real return. A declining rate of exchange will lessen the purchasing power of income and currency derived from any returns.
The exchange rate can affect other income factors like interest rates, inflation, and capital returns from domestic securities. Thus, currency value and the exchange rate should be analysed thoroughly before investing.