There are various factors that influence the forex market. They include; inflation, exchange rate, and interest rates. Among the aforementioned factors, exchange rate remains among the most critical elements in fx trading Australia. Traders throughout the globe, analyze and watch exchange rates keenly because they influence their portfolio. What then determines exchange rate fluctuations?
Fluctuations in exchange rates can influence trading relationships between different countries. For instance, when currencies are high, a country’s import costs become cheaper while the export costs become costly in alien markets.
On the other hand, imports will be costly when currencies are low while exports will be cheaper in alien markets. When the exchange rates are high, the balance of trade in that specific country is likely to reduce. Low exchange rates increase the balance of trade.
What Dictates Exchange Rates?
Exchange rates are dictated by various factors, all of which are affiliated to trading connection between two nations. Below are some of the factors that dictate the exchange rate.
· Inflation Differentials
Any country with a steady low inflation rate displays a high currency value due to an increase in the country’s purchasing power. Countries with consistent high inflation rates experience currency depreciation in comparison to currencies from their trading associates and this comes with increased interest rates.
· Interest Rate Differentials
There is a relationship between inflation, interest rates, and exchange rates. When interest rates are manipulated, central banks put an impact on exchange rates and inflation. In addition, currency values and inflation are influenced when interest rates are altered. Increased interest rates increases returns for the lenders.
This means that high interest rates increase the exchange rate and draw foreign capital. However, the effect of high interest rates is reduced when a country’s inflation is high in comparison to other countries. This can also be as a result of various other factors which may drag down the currency. When the interest rates are low, the exchange rates decrease.
· Shortfall in the Current Account
The balance of trade between one nation and its trading associates is defined as the current account. It shows all transactions between nations for services, goods, dividends and interest. A shortfall in the current account indicates that a nation is earning less and allocating more money to foreign trade.
It also indicates that the nation is getting foreign monetary assistance in order to cater for the shortfall. This causes an increased demand for foreign currency which reduces the nation’s exchange rate. This trend continues to the point where foreign goods and services become too costly to trigger domestic sales and too cheap for investors.
· Trading Terms
Trading terms is an allocation that compares import and export prices. They are affiliated with balance of payments and current accounts. When a country’s exports are more than the imports it means that the trading terms have improved significantly. Increasing the trading terms, means there will be a huge demand for the exports, and this results in increased income from exports.
· Public Debt
Nations source for funding in order to finance public projects. Even though such projects play a major role in domestic economy growth, foreign investors tend to shun countries with a high public debt or shortage. This is because such countries are likely to experience an increase in inflation.
When inflation is high, a nation may be forced to print money in a bid to offset a fraction of its debt. However, inflation will thrive when there is an increased supply of money. When governments are not in a position to adopt domestic means in order to take care of its deficit, there must be an escalation of securities to auction to foreigners in order to lower their price.
When foreigners opine that a country may not pay back the debt due to its magnitude, they may lose interest in the currencies securities. This is why a nation’s debt rating plays a major role in its exchange rate.
Foreign investors are interested in steady countries with robust economic achievement where they can invest in. Nations that demonstrate positive characteristics attract investment funds from nations seen to have high economic risks.