Apart from factors like interest rates and inflation, the currency exchange rate is among the most important determinants of a country’s relative level of economic health. Also, exchange rates play a crucial role in a country’s level of trade. And this is critical to nearly every free market economy around the globe. With this, exchange rates became part of the most observed, analyzed, and governmentally manipulated economic measures. However, these matter on smaller scales, too; they affect the real return of an investor’s portfolio.
Aside from that, there are a lot of factors determining exchange rates. A lot of these factors are linked to the trading relationship between the two countries. Keep in mind that exchange rates are relative. And they are expressed as a comparison of the currencies of two countries.
Here, there will be some of the principal determinants of the exchange rate between the two countries.
Differentials in Inflation
Usually, a country with a typically lower inflation rate displays an increasing currency value, as its purchasing power boosts relative to other countries. In the last half of the 20th century, countries with low inflation involved Japan, Germany, and Switzerland. On the other hand, the U.S. and Canada reached low inflation only later. Then, countries with higher inflation often see depreciation in their currency about the currencies of their trading partners. Also, higher interest rates typically accompany this.
Differentials in Interest Rates
The exchange rates, inflation, and interest rates are all deeply correlated. By manipulating interest rates, central banks use influence on both inflation and exchange rates. And it changes interest rates impact inflation and currency values.
Also, higher interest rates offer lenders in an economy a more significant return relative to other countries. Thus, higher interest rates lure foreign capital and cause the exchange rate to increase. But the effect of higher interest rates is mitigated if inflation in the country is way higher compared in others, or if additional factors serve to drag the currency down. Then, the opposite relationship exists for decreasing interest rates, and that is lower interest rates lead to lessening exchange rates.
Current Account Deficits
Now, the current account is the balance of trade between a country and its trading partners. It reflects every payment made between countries for goods, services, interest, and dividends. Then, a deficit in the current account shows that the country is spending more on foreign trade than it is earning, and it means it borrows capital from foreign sources to make up the deficit.
To put it differently, the country needs more foreign currency than it gets through sales of exports, and it supplies more of its currency compared to foreigners’ demand for its products.
Furthermore, excess demand for foreign currency lowers the exchange rate of the country until domestic goods and services become cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.