How Do Currency Exchange Rates Work?
Currency Exchange rates refer to the worth of your currency when converted to a foreign currency. There is no constant exchange rate due to the active trading that goes on with currencies. It is why the rate increases and decreases. Think of it like stock market trading or the sale of valuables. You’ll realize that there isn’t a static rate for them and it is the same with exchange rates.
You might think only people who import and export goods and services should care about exchange rates but that’s not the case. When you travel from one country to another, you’ll need to exchange currencies to the one in use in whatever country you find yourself in. Yet, when you exchange currencies, you’ll notice that you’ll either get more or less of the currency in the country you’re in. Let’s explore why.
Some Factors That Affect Exchange Rate
Different factors affect the exchange rate. Here are some of them:
- Rate of inflation
Market inflation can affect currency exchange rates. A country with a higher inflation rate than the other will witness a depreciation in its currency’s value and vice versa. What this means is that if you try to exchange your currency to another one, you’ll likely get less of the currency you’re changing to because your country’s currency has been suppressed.
- Political Stability
Many countries in the world are going through and have been going through political instability for some time now. This has led to the currency severely being depreciated because of the lack of foreign investment. Foreign investors may stay away because of widespread corruption and the assumption of too much risk when investing in a politically unstable country.
- Recession
Thus, recessions can sometimes have a beneficial or negative effect on a country’s currency.
- Reading an Exchange Rate
Here is an example of how to convert currencies:
If the EUR/AUD currency pair is 1.56 (just an example), it only means that 1 Euro equals to 1.56 Australian Dollar. Therefore, it shows much AUD (second currency) is needed to buy a single unit of EUR (first currency).
To calculate how much first currency (EUR) you’ll need to purchase the second currency (AUD), you will use this formula: 1/exchange rate.
With the example provided above, it will be 1/1.56=0.6410. It means that it costs 0.6410 Euros to purchase 1 Australian Dollar.
To calculate how much first currency (EUR) you’ll need to purchase the second currency (AUD), you will use this formula: 1/exchange rate.
With the example provided above, it will be 1/1.56=0.6410. It means that it costs 0.6410 Euros to purchase 1 Australian Dollar.
How Exchange Rates Concern You
If you are a traveller going to another country that uses a different currency, exchange rate values concern you. For example, if you an American and the US Dollar is strong at the time of your travel, you’ll enjoy the luxury of purchasing more foreign currency and enjoying a relatively cheaper trip. If it’s the other way round, your journey becomes more expensive and you’ll get less foreign currency.
If you’re a person who does business by importing and exporting goods, exchange rates concern you, as well. If your currency has a higher value than the country you’re buying goods from, you’ll purchase more goods but if it’s lower, you should expect to pay more money for those goods.
If you are a traveller going to another country that uses a different currency, exchange rate values concern you. For example, if you an American and the US Dollar is strong at the time of your travel, you’ll enjoy the luxury of purchasing more foreign currency and enjoying a relatively cheaper trip. If it’s the other way round, your journey becomes more expensive and you’ll get less foreign currency.
If you’re a person who does business by importing and exporting goods, exchange rates concern you, as well. If your currency has a higher value than the country you’re buying goods from, you’ll purchase more goods but if it’s lower, you should expect to pay more money for those goods.
Exchange Rate Changes
The foreign exchange market is always active. There is no period of inactivity because it is not time-bound. It operates 24 hours a day, including weekends. Therefore, exchange rates fluctuate based on events and trends.
The foreign exchange market is always active. There is no period of inactivity because it is not time-bound. It operates 24 hours a day, including weekends. Therefore, exchange rates fluctuate based on events and trends.
How to Determine Currency Exchange Rates
Currency rates are deeply rooted in the laws of barter. It works based on supply and demand. A currency that is doing well will be more demanded than other currencies that aren’t particularly strong at the moment. The more demand a currency has, the higher it’s value will be and this will impact its price as well.
Since there is a limited supply of such currencies and a high demand for them, they are valued at high prices. Here’s an example: if the Canadian economy is soaring high, Australian investors might be interested in Canadian dollars. Since Canadian dollars has become the in-demand currency, the Australian investors would have to part with more Australian dollars to purchase Canadian dollars.
9 Factors That Influence Currency Exchange Rates
Currency rates are deeply rooted in the laws of barter. It works based on supply and demand. A currency that is doing well will be more demanded than other currencies that aren’t particularly strong at the moment. The more demand a currency has, the higher it’s value will be and this will impact its price as well.
Since there is a limited supply of such currencies and a high demand for them, they are valued at high prices. Here’s an example: if the Canadian economy is soaring high, Australian investors might be interested in Canadian dollars. Since Canadian dollars has become the in-demand currency, the Australian investors would have to part with more Australian dollars to purchase Canadian dollars.
9 Factors That Influence Currency Exchange Rates
- Inflation.
- Interest Rates.
- Public Debt.
- Political Stability.
- Economic Health.
- Balance of Trade.
- Current Account Deficit.
- Confidence/ Speculation.
- Government Intervention
Although it is not always easy to understand, track, or even anticipate these factors, it pays to know them, especially if you are interested in foreign currency. It is worth noting that these factors affect currency exchange rates at a macroeconomic level, meaning they affect global currency exchange rates and not local exchange rates.
1. Inflation
Inflation is the relative purchasing power of a currency compared to other currencies. For example, it might cost one unit of currency to buy an apple in one country but cost a thousand units of a different currency to buy the same apple in a country with higher inflation. Such differentials in inflation are the foundation of why different currencies have different purchasing powers and hence different currency rates. As such, countries with low inflation typically have stronger currencies compared to those with higher inflation rates.
2. Interest Rates
Interest rates are tightly tied to inflation and exchange rates. Different country’s central banks use interest rates to modulate inflation within the country. For example, establishing higher interest rates attracts foreign capital, which bolsters the local currency rates. However, if these rates remain too high for too long, inflation can start to creep up, resulting in a devalued currency. As such, central bankers must consistently adjust interest rates to balance benefits and drawbacks.
3. Public Debt
Most countries finance their budgets using large-scale deficit financing. In other words, they borrow to finance economic growth. If this government debt outpaces economic growth, it can drive up inflation by deterring foreign investment from entering the country, two factors that can devalue a currency. In some cases, a government might print money to finance debt, which can also drive up inflation.
4. Political Stability
A politically stable country attracts more foreign investment, which helps prop up the currency rate. The opposite is also true – poor political stability devalues a country’s currency exchange rate. Political stability also affects local economic drivers and financial policies, two things that can have long term effects on a currency’s exchange rate. Invariably, countries with more robust political stability like Switzerland have stronger and higher valued currencies.
A politically stable country attracts more foreign investment, which helps prop up the currency rate. The opposite is also true – poor political stability devalues a country’s currency exchange rate. Political stability also affects local economic drivers and financial policies, two things that can have long term effects on a currency’s exchange rate. Invariably, countries with more robust political stability like Switzerland have stronger and higher valued currencies.
5. Economic Health
Economic health or performance is another way exchange rates are determined. For example, a country with low unemployment rates means its citizens have more money to spend, which helps establish a more robust economy. With a stronger economy, the country attracts more foreign investment, which in turn helps lower inflation and drive up the country’s currency exchange rate. It is worth noting here that economic health is more of a catch-all term that encompasses multiple other drivers like interest rates, inflation, and balance of trade.
6. Balance of Trade
Balance of trade, or terms of trade, is the relative difference between a country’s imports and exports. For example, if a country has a positive balance of trade, it means that its exports exceed its imports. In such a case, the inflow of foreign currency is higher than the outflow. When this happens, a country’s foreign exchange reserves grow, helping it lower interest rates, which stimulates economic growth and bolsters the local currency exchange rate.
7. Current Account Deficit
The current account deficit is closely related to the balance of trade. In this scenario, a country’s balance of trade is compared to those of its trading partners. If a country’s current account deficit is higher than that of a trading partner, this can weaken its currency relative to that country’s currency. As such, countries that have positive or low current account deficits tend to have stronger currencies than those with high deficits.
8. Confidence/ Speculation
Sometimes, currencies are affected by the confidence (or lack thereof) traders have in a currency. Currency changes from speculation tend to be irrational, abrupt, and short-lived. For example, traders may devalue a currency based on an election outcome, especially if the result is perceived as unfavorable for trade or economic growth. In other cases, traders may be bullish on a currency because of economic news, which may buoy the currency, even if the economic news itself did not affect the currency fundamentals.
Economic health or performance is another way exchange rates are determined. For example, a country with low unemployment rates means its citizens have more money to spend, which helps establish a more robust economy. With a stronger economy, the country attracts more foreign investment, which in turn helps lower inflation and drive up the country’s currency exchange rate. It is worth noting here that economic health is more of a catch-all term that encompasses multiple other drivers like interest rates, inflation, and balance of trade.
6. Balance of Trade
Balance of trade, or terms of trade, is the relative difference between a country’s imports and exports. For example, if a country has a positive balance of trade, it means that its exports exceed its imports. In such a case, the inflow of foreign currency is higher than the outflow. When this happens, a country’s foreign exchange reserves grow, helping it lower interest rates, which stimulates economic growth and bolsters the local currency exchange rate.
7. Current Account Deficit
The current account deficit is closely related to the balance of trade. In this scenario, a country’s balance of trade is compared to those of its trading partners. If a country’s current account deficit is higher than that of a trading partner, this can weaken its currency relative to that country’s currency. As such, countries that have positive or low current account deficits tend to have stronger currencies than those with high deficits.
8. Confidence/ Speculation
Sometimes, currencies are affected by the confidence (or lack thereof) traders have in a currency. Currency changes from speculation tend to be irrational, abrupt, and short-lived. For example, traders may devalue a currency based on an election outcome, especially if the result is perceived as unfavorable for trade or economic growth. In other cases, traders may be bullish on a currency because of economic news, which may buoy the currency, even if the economic news itself did not affect the currency fundamentals.
9. Government Intervention
Governments have a collection of tools at their disposal through which they can manipulate their local exchange rate. Primarily, central banks are known to adjust interest rates, buy foreign currency, influence local lending rates, print money, and use other tools to modulate currency exchange rates. The primary objective of manipulating these factors is to ensure favorable conditions for a stable currency exchange rate, cheaper credit, more jobs, and high economic growth.
Conclusion:
Factors that influence currency exchange rates are important for various reasons. For countries, these factors can affect how one country trades with another. For individuals, these factors affect how much money one can get when exchanging one currency for another.
0 Comments