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. 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.
In this article, we highlight nine factors that affect currency exchange rates, starting with the most significant factor – inflation.
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.
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.
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.
Currency exchange rates are commonplace for travelers, bankers, international investors, and businesses with global trade. For people not involved in these fields, an exchange rate may seem a bit confusing. Before we look at how to read and calculate currency exchange rates, it is necessary first to define what it is.
An exchange rate is the amount of one currency you need to buy another currency. For example, if you have 100 US dollars and want to buy Euros, how many Euros will you get for your money? Looking at the Euro and USD exchange rate will give you this information.
But which exchange rate should you consider? EUR/USD or USD/EUR?
How to Read Exchange Rates
Exchange rates are written as currency pairs.
For example:
- USD/EUR (US Dollar/European Euro)
- USD/CAD (US Dollar/Canadian Dollar)
- USD/AUD (US Dollar/Australian Dollar)
- USD/JPY (US Dollar/Japanese Yen)
- USD/GBP (US Dollar/British Pound)
In these pairs, the first currency (USD in this case) is called the base currency and the second currency (in this case Euro, Canadian Dollar, etc.) is called the term currency or quote currency.
Let’s say you see a currency exchange rate saying USD/EUR is 0.88, what does this mean?
It means that you need 0.88 Euros to buy 1 US dollar.
Going back to the currency pair, the rate is read as how much of the second currency (quote currency) is needed to buy one unit of the first currency (base currency). In this case, to reiterate, you need 0.88 Euros to buy 1 US dollar.
What if you see a rate written EUR/USD?
You can apply the same process to read this currency pair: how many US dollars do you need to buy 1 Euro. In this case, the exchange rate is 1.13. That is, you need 1.13 US dollars to buy 1 Euro.
You can use the same method to determine the value of all the other pairs:
- USD/CAD (The number of Canadian dollars you need to buy 1 US Dollar)
- USD/AUD (The number of Australian dollars you need to buy 1 US Dollar)
- USD/JPY (The number of Japanese Yen you need to buy 1 US Dollar)
- USD/GBP (The number of British Pounds you need to buy 1 US Dollar)
Now that you know how to read a currency exchange rate let us now turn to how to calculate the exchange rate.
How to Calculate Exchange Rates
The best way to understand how to calculate an exchange rate is to use an example.
Let’s say you run a business in the United States that relies on international suppliers. One of your suppliers, who is in Australia, sent you a shipment worth $35,000 Australian Dollars. How many US dollars should you send them to cover the amount?
AUD/USD
In this case, should you look for the USD/AUD rate or the AUD/USD rate? It may sound confusing, but there is an easy way to approach it. Since your supplier wants to be paid in Australian Dollars, you need to buy that currency with your US dollars.
That means you need to find out how many US dollars you need to buy one Australian dollar. Since the Australian Dollar unit is one, then it is the base currency (i.e., the first currency in the pair).
Thus, you will write the pair as AUD/USD, which asks how many USD you need to buy one AUD.
Now go to a currency exchange quote provider online like XE.com and look for the AUD/USD exchange rate.
Currently, it is 0.7.
That means you need 0.7 USD dollars to buy 1 Australian dollar.
Now, multiply the amount you owe by 0.7
$35,000 x 0.7 =$ 24,500
You need $24,500 US dollars to purchase and send $35,000 Australian dollars.
Reversing the Calculation
What if you are the supplier and are owed $35,000 USD by an Australian business?
They would simply reverse the currency pair to USD/AUD (how many Australian dollars are needed to buy 1 US dollar)
In this case, they would need to spend AU$1.43 for every dollar they buy.
$35,000 x 1.43 = $50,000
They would need to spend AU$50,000 to buy and send you US$35,000
A Word on Spreads
When calculating currency exchange rates, it is essential to factor in spreads. Spreads are the extra margin (or percentage points) brokers add to each transaction. Spreads are the reason the rate your local banks quote you will always differ from what you see on the Internet. When calculating and negotiating exchange rates, always keep in mind that these spreads can be quite high and can influence how much of another currency you get for your money.
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.
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
The political affairs of a country can affect its currency’s value. A country battling political instability can be a risky investment for foreign investors. It likely means that the foreign capital in the country will decrease over time, and the domestic currency’s value will depreciate.
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
A recession can have a big impact on a country’s currency. Generally, during a recession, inflation tends to fall and this may lead to an increase in demand for that country’s currency. However, in other instances, when a country falls into a recession, it’s usually a signal to other investors that economic conditions are weak in that country and their currency may ultimately suffer because of this.
Thus, recessions can sometimes have a beneficial or negative effect on a country’s currency.
Reading an Exchange Rate
An exchange rate is usually presented in pairs. You’ll have one currency paired with another one. What this means is the first currency in the pair is the base and the value should be $1. The next figure is how much of that currency it will take to purchase $1 of the base currency.
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.
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.
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.
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.
Conclusion
Currency exchange rates play a crucial role in the way everyday people live their lives. A favourable exchange rate will often get them more of the currency they are exchanging to. However, a less in-demand currency means they will have to use more of their home country’s currency to exchange for another foreign currency.
