5 Factors That Influence Exchange Rates

Reviewed by Thomas BrockFact checked by Vikki VelasquezReviewed by Thomas BrockFact checked by Vikki Velasquez

A nation’s currency exchange rate is one of the most important determinants of its economic health. Along with interest rates and inflation rates, exchange rates play a vital role in a nation’s level of trade, which is critical to nearly every free market economy in the world.

For this reason, exchange rates are among the most watched and analyzed economic numbers, and among those most subject to government manipulation.

But exchange rates matter on a smaller scale as well: they impact the real return of an investor’s portfolio.

Key Takeaways

• Aside from factors such as interest rates and inflation, the currency exchange rate is one of the most important determinants of a country’s economic health.
• A higher-valued currency makes a country’s imports less expensive at home and its exports more expensive in foreign markets.
• Exchange rates are always relative and are expressed as a comparison of the currencies of two countries.

Overview of Exchange Rates

Currency rates constantly fluctuate, making them worth more or less in comparison with other currencies.

A rise in the value of its currency makes a nation’s imports less expensive for its citizens to buy and its exports more expensive for consumers in foreign markets. A decrease in the value of its currency makes its imports more expensive and its exports less expensive in foreign markets.

A higher exchange rate can be expected to damage a country’s balance of trade. That is, the country is making less on its exports and spending more on its imports. A lower exchange rate can be expected to improve the balance of trade.

Determinants of Exchange Rates

The ups and downs of a nation’s exchange rate reflect many factors. Each of these factors is related to the trading relationship between the nation and its major trading partners. Exchange rates are relative, and are expressed as a comparison of the currencies of two countries.

The following are some of the principal determinants, in no particular order. The relative importance of these factors is subject to debate.

1) Differentials in Inflation

A country with a relatively low inflation rate usually experiences a higher currency value, as its purchasing power increases relative to other currencies.

During the last half of the 20th century, the countries with low inflation included Japan, Germany, and Switzerland, while the U.S. and Canada achieved low inflation only later.

Countries experiencing higher inflation typically see depreciation in their currency versus the currencies of their trading partners. This is also usually accompanied by higher interest rates.

2) Differentials in Interest Rates

Interest rates, inflation, and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and interest rate changes have an impact on inflation and currency values.

Higher interest rates offer banks and other lenders a better return relative to other countries. Higher interest rates attract foreign capital and cause the exchange rate to rise.

The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors drive the currency down.

The opposite relationship exists for decreasing interest rates. That is, lower interest rates tend to decrease exchange rates.

3) Current Account Deficits

The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest, and dividends.

A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products.

The excess demand for foreign currency lowers the country’s exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

4) Public Debt

Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors.

The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.

In the worst-case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds or increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices.

Finally, a large debt may prove worrisome to foreign investors if they believe the country is at risk of defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency.

For this reason, the country’s debt rating (as determined by Moody’s or Standard & Poor’s, for example) is a crucial determinant of its exchange rate.

5) Terms of Trade

A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments.

If the price of a country’s exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country’s exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country’s currency (and an increase in the currency’s value).

If the price of exports rises by a smaller rate than that of its imports, the currency’s value will decrease in relation to those of its trading partners.

How Currency Rates Influence Investment

Foreign investors and foreign companies seek out stable countries with strong economies in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk.

Political turmoil, in particular, can cause a loss of confidence in a currency and a movement of capital to more stable countries.

What Exactly Is an Exchange Rate?

An exchange rate is the value of a nation’s currency in comparison to the value of another nation’s currency. These values fluctuate constantly.

In practice, most world currencies are compared against a few major benchmark currencies including the U.S. dollar, the British pound, the Japanese yen, and the Chinese yuan.

So, if it’s reported that the Polish zloty is rising in value, it means that Poland’s currency (and its export goods) are worth more dollars or pounds.

What Impact Do Currency Rates Have on Real People?

For consumers, a lower currency value means imported goods get pricier. A higher currency value means imported goods are more affordable. That’s highly relevant in most countries, where products like electronics and cars are mostly imported.

For investors, a change in currency values can help or hurt the real return they’re getting on their investments. Firstly, the dollars (or yen or yuan) that they have accumulted may be worth less than they were. Secondly, the change in currency value can damage the profits of the companies they invest in.

Is a Strong Currency Good or Bad?

It depends. If you’re traveling abroad, a strong U.S. dollar, for example, means you’ll get more pounds or euros for your dollars. The tourism business in the U.S. may suffer since a strong dollar will make it more expensive for visitors to the U.S.

The strong dollar also will make American goods pricier abroad. That may mean higher profits for U.S. companies, or it may lead foreign consumers to pick cheaper local alternatives.

The Bottom Line

Changes in exchange rates can have a real impact on investors’ portfolios.

The exchange rate of the currency in which a portfolio holds the bulk of its investments determines that portfolio’s real return. A declining exchange rate decreases the purchasing power of income and capital gains derived from any returns.

Moreover, the exchange rate influences other income factors such as interest rates, inflation, and even capital gains from domestic securities.

While exchange rates are determined by complex factors that can leave even economists flummoxed, investors should still keep an eye on exchange rates, as they play an important role in the rate of return on their money.

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