A healthy exchange rate is crucial to a country’s economic success as it affects how it is able to trade with other nations in the forex marketplace. If a country has a comparatively low currency, this makes its exports cheaper and imports more expensive in a foreign market, whereas the opposite is true for a country with a high value currency. The rate of exchange between two countries is affected by a number of factors within the Forex market.
A country that performs well in the global economy is likely to be an attractive proposition for potential investors. Instability, whether due to political upheaval or economic downturn, can have a negative effect on a country’s economic performance. A stable and strongly-performing country will inspire confidence in the currency and improve forex rates.
Inflation and interest rates
The rate of inflation can have a significant effect on a country’s rate of exchange on the Forex market. If the rate of inflation remains consistently low, the currency has increased purchasing power compared to that of countries where the rate of inflation is higher. Countries with these higher rates will find the value of their currency depreciating against those with a lower rate. If a government chooses to combat rising inflation rates by increasing the amount of money in circulation, for example by printing more notes, this devalues the existing currency.
Spiralling rates lead to the scenario whereby ever-larger denominations are required for people to make even the most basic of purchases. Eventually the currency is not worth the paper it is printed on. A case in point is that of the Turkish lira. In 1995, 1USD was worth approximately 45,000 lira, but by 2001 the lira had slumped so far that 1USD equated to 1,650,000 lira. The only solution was redenomination, culminating in the introduction of the new lira in 2005, where 1USD was valued at approximately 1.29 new Turkish lira. Rates of inflation are also linked to interest rates, in turn affecting exchange rates. Higher interest rates are beneficial to savers, so offer potential investors more substantial returns. This is attractive to forex investors, causing the exchange rate to rise.
National debt and current account deficits
Although a country investing in its own growth can be an indicator of economic success, too much spending can lead to excessive public debt. A large public deficit can cause inflation rates to rise, affecting the value of the currency. A country’s current account refers to the details of all its trade with other nations, be this goods, services or interest. If more is spent on foreign trade than is earned, a country may borrow foreign capital to make up the deficit. The demand for foreign currency will push down a country’s own exchange rate until its goods and services are cheap enough to appeal to foreign territories.
There are a variety of factors that affect a country’s forex rate. Each contributes in different ways and with differing degrees of significance to influence the rate of exchange and impact on global trading relations.
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