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What are some factors that influence exchange rates?

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Quick Answer

Some factors that influence the exchange rate are differentials in inflation, public debt, interest rates, current account deficits, terms of trade, political stability and economic performance. These factors are related to the trading relationship between two countries. .

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Full Answer

A lower inflation rate raises the currency value of a country, leading to a relative increase of purchasing power to other currencies. Countries with higher inflation rates experience currency depreciation in relation to the currency of their trading partners. Higher interest rates mean higher returns for the lenders compared to other countries; in turn, it attracts foreign capital, causing the exchange rates to raise. Decreased interest rates lower the exchange rates.

Current account deficit means that a country spends more on imports than it earns from exports, leading to depleting foreign-exchange reserve. It also means that foreign sources fund the capital deficit. The excess demand for foreign currencies lowers the exchange rate. A country also experiences similar demand when there is a huge public debt that requires foreign currency for repayment. The terms of trade also have an influence on the current account.

A country that is politically stable and has a strong economy attracts foreign investments. These positive attributes bring confidence to the currency and cause movement of capital from unstable countries.

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