Inflation rates, interest rates, political stability and economic performance are some of the key factors that affect foreign currency exchange rates. These factors influence the variations and fluctuations in foreign exchange rates and are the reasons for their volatility.
Changes in demand-pull or cost-push market inflation can cause an increase or a decrease in foreign exchange rates. A country experiencing low inflation rates exhibits a rising value of its currency. Consequently, high inflation rates result in depreciation of a currency’s foreign exchange value.
Changes in a country’s interest rates can affect its currency exchange rate negatively or positively. If interest rates increase, the foreign exchange rates also increase. This is because higher interest rates provide higher rates for lenders. Thus, lenders are willing to give more loans so that they earn more interest. An increase of the money in circulation results into low foreign exchange rates.
If the risks of political turmoil are low, foreign investors are likely to invest more. They may do this by drawing their investments away from nations that are unstable politically or economically. An increase in the foreign capital causes an appreciation in the value of a domestic currency. The financial policies adopted by a nation may also increase or decrease its foreign exchange rates. An expansionary monetary policy lowers the foreign exchange rates, while a contractionary or restrictive monetary policy increases foreign exchange rates.