Aside from factors such as interest rates and inflation, the currency exchange rate is one of the most important determinants of a country's relative level of economic health. Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched, analyzed and governmentally manipulated economic measures. But exchange rates matter on a smaller scale as well: they impact the real return of an investor's portfolio. Here, we look at some of the major forces behind exchange rate movements.
Main Factors that Influence Exchange Rates
Overview of Exchange Rates
Before we look at these forces, we should sketch out how exchange rate movements affect a nation's trading relationships with other nations. A higher-valued currency makes a country's imports less expensive and its exports more expensive in foreign markets. A lower-valued currency makes a country's imports more expensive and its exports less expensive in foreign markets. A higher exchange rate can be expected to worsen a country's balance of trade, while a lower exchange rate can be expected to improve it.
KEY TAKEAWAYS
Aside from factors such as interest rates and inflation, the currency exchange rate is one of the most important determinants of a country's relative level of economic health.
A higher-valued currency makes a country's imports less expensive and its exports more expensive in foreign markets.
Exchange rates are relative and are expressed as a comparison of the currencies of two countries.
Determinants of Exchange Rates
Numerous factors determine exchange rates. Many of these factors are related to the trading relationship between the two countries. Remember, exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries. Note that these factors are in no particular order; like many aspects of economics, the relative importance of these factors is subject to much debate.
Differentials in Inflation
Typically, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the 20th century, the countries with low inflation included Japan, Germany, and Switzerland, while the U.S. and Canada achieved low inflation only later.1 Those countries with higher inflation typically see depreciation in their currency about the currencies of their trading partners. This is also usually accompanied by higher interest rates.
Differentials in Interest Rates
Interest rates, inflation, and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates – that is, lower interest rates tend to decrease exchange rates.
Current Account Deficits
The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest, and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency.