What are the most important factors which influence exchange rates?

Before undertaking a currency investment, you must understand the forces that drive exchange rates. Many of these factors are intangible or psychological, so they are impossible to characterize. However, those factors, which are generally recognized as fundamental determinants, are spelled out below.

Inflation

Generally, 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 twentieth century, the countries with low inflation included Japan, Germany, and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see a depreciation in their currency compared to the currencies of their trading partners. This is also usually accompanied by higher interest rates.

Interest Rates

The correlation between a nation’s interest rate and its exchange rate is easy to grasp. We would expect savvy investors to invest their money where, for a given level of risk, the returns are highest.  Thus, when a disparity in interest rates exists between countries whose risk of default is equal, investors would likely lend to the country that offered the higher interest rate. To invest in or lend to another country, one must first obtain that nation’s currency. This increases demand for that nation’s currency and causes it to appreciate.   

Current Account/Trade Balance

When a country runs a current account deficit, it typically means that the nation imports more than it exports. This tends to skew the exchange rate in favor of the country that runs a trade surplus, as foreign demand for its currency must be comparatively high. In due course, the exchange rate may adjust to make the first nation’s products affordable to foreigners and bridge the gap between imports and exports. 

Public (government) debt

The relationship between government debt obligations and its exchange rate is not as cut-and-dry. Government borrowing to finance deficit spending increases inflation, which eats into the value of that nation’s currency. In addition, if lenders believe there is any risk of default, they may sell the debt (in the United States, this debt takes the form of Treasury securities) on the open market, exerting downward pressure on the exchange rate.

Political and Economic Factors

Most investors are risk-averse; accordingly, they will invest their capital where there is a certain degree of predictability. They tend to avoid investing in countries that are typified by governmental instability and/or economic stagnation. In contrast, they will invest capital in stable countries with strong signs of economic growth. A nation whose government and economy are perennially stable will attract the most investment. This, in turn, creates demand for that nation’s currency and causes its currency to appreciate.