Where economic theory will affect the Forex market on a long-term basis, the effect of changes in economic data is much more immediate.
News and information regarding a country's economy can have a direct impact on the direction that the country's currency is heading in much the same way that current events and financial news affect stock prices, hence the importance of economic factors. The following eight economic factors will directly affect a currency's movements in the Forex market.
8 factors affecting exchange rates
Interest and inflation rates
Inflation is the rate at which the cost of goods and services rises over time. Interest rates indicate the amount charged by banks for borrowing money. These two are linked by the fact that people tend to borrow and spend more when the interest rates are low, which results in an increase in costs. These rates are direct indicators of the current and future economic performance of a country and can influence the decisions of forex investors and traders throughout the globe. An increase in interest rate is usually followed by a rise in the value of the local currency. This happens usually because the economy is growing too fast and central banks are trying to slow inflation.
Current account deficits
The current account is the balance of trade between a country and its trading partners. It describes the difference in value between the goods and services traded with other countries. If a country buys more than it sells then the balance of trade is a deficit. It directly affects the exchange rate since a country will need more foreign capital, thus diminishing the demand for local currency. This excess supply of local currency drives down its value against foreign currency.
Government debt is public debt or national debt owned by the central government. A country with government debt is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their bonds in the open market if the market predicts government debt within a certain country. As a result, a decrease in the value of its exchange rate will follow.
Terms of trade
Terms of trade are the ratio of the export prices of a country to its import prices. When the export prices of a country rise at a greater rate than its import prices, its terms of trade improves. This in turn results in higher revenue, higher demand for the country’s currency, and an increase in the value of the currency. This cumulatively results in appreciation of the exchange rate of the currency.
One of the many factors that affect the economic performance of a country is its political stability. A country, which has a stable political environment, attracts more foreign investment and vice versa. An increase in foreign capital results in appreciation in the value of its domestic currency. Such stability also directly affects the financial and trade policy, thus eliminating any uncertainty in the value of its currency.
During a recession, a country’s interest rates are likely to fall, thus decreasing its chances to acquire foreign capital. This in turn weakens the currency of the country in question, weakening the exchange rate.
Investors demand more of a country’s currency when its value is expected to rise to make a profit in the near future. As a result, the value of the currency rises due to its increased demand. Which in turn results in a rise in the exchange rate as well.
With so many factors involved, exchange rates are subject to fluctuations and that can be pretty distressing for people who transfer money overseas frequently. Though watching the rates of a currency corridor can give you a fair idea of the best time to make transfers, it’s best to stay updated about the real-time exchange rates.
Gross Domestic Product
This is the measurement for goods and services that were finished over a period of time. The GDP is broken down into 4 categories:
- Business spending
- government spending
- Private consumption
- Total net exports
All of the above factors determine the foreign exchange rate fluctuations.
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