Economic
health came under increased scrutiny through 2020, as the coronavirus pandemic
swept across the globe and wiped an estimated
4.9% from the world’s economy.
There are a
number of ways in which you can gauge a nation’s economic prosperity, of
course, with the so-called “currency exchange rate” one of the most
influential. This refers to the value of one nation’s currency against others,
with the forex market seeing currencies traded in pairs according to constant,
real-time price fluctuations.
But what are the key factors that influence the currency exchange rate each and every day? Here are three of the most important.
1. The Rate of Inflation
Inflation
refers to the rate at which prices increase over time, resulting in a fall in
the purchasing value of money as a result.
Lower
inflation is typically indicative of a relatively healthy overall economy,
while it tends to support a rising currency value with increased spending power
relative to other assets in the forex marketplace.
Throughout
the 20th century, economic powerhouses such as Switzerland, Japan and Germany
displayed consistently low inflation rates, while the rate in nations such as
the US and the UK has fluctuated considerably.
As inflation rates rise, however, the value of a nation’s currency tends to depreciate. This may be accompanied by increased interest rates, which also have a considerable impact on the value of national currencies.
2. The Base Interest Rate
There’s
undoubtedly a strong and demonstrable correlation between the rates of
inflation, interest and exchange rates, which is partially why each three are
such strong economic indicators.
A country’s
base interest rate is usually set as a key element of monetary policy, usually
in line with the wider economic climate. In 2020, for example, most nations
slashed their base rate as part of wider quantitative easing measures, in
response to the economic damage caused by the coronavirus.
This had the
impact of lowering and undermining respective currency prices, as international
demand declines and capital inflows are reduced. Conversely, higher interest
rates offer lenders in any economy a higher return relative to other countries,
attracting foreign
capital and causing the exchange rate to rise noticeably as a result.
This is why tools like the economic calendar are so popular amongst forex traders, as they enable investors to monitor key data releases (including the details of monetary policy) and tailor their strategies as a result.
3. Currency Account Deficits
The currency
account refers to the balance of trade between a country and its various
trading partners, reflecting all payments made between nations for services,
goods, dividends and interest.
Simply, if
one country has a deficit with another, this means that it’s spending more on
foriegn trade that it’s earning. This also indicates that it may be borrowing
capital from foreign sources to make up this deficit, allowing a higher
debt-to-GDP ratio to develop over time.
This also
translates into an excess demand for foreign currency, which lowers the
nation’s exchange rate until domestic goods and services become cheap enough
for overseas investors.
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