The top factors influencing currency exchange rates

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Not only is the forex market one of the biggest entities of its type in the world (with a cumulative value that’s around 2.5-times the size of the world’s GDP), but the performance of each nation’s currency is also a key indicator of economic health.

The main reason for this is that a nation’s currency rate is actively influenced by a number of macroeconomic factors, from the base interest rate to the cumulative amount of public debt recorded.

In this post, we’ll appraise some of these factors while asking how they impact on currency exchange rates across the globe.

1. The Base Rate of Interest

The base interest rate is arguably the single most important aspect of monetary policy, as this has a direct impact on everything from variable mortgage rate to value of savings held in bank accounts.

Central banks also tend to increase the base interest rate during times of prosperity, creating an increased demand for the underlying currency and optimising a nation’s capital inflows.

Conversely, the base interest rate is often reduced during times of austerity, as part of wide quantitative easing measures (such as those that have been rolled out during the coronavirus pandemic).

This causes the value of respective currencies to rise and fall respectively, which you’ll know if you’ve ever traded through a corporeal or forex demo account.

2. Public Debt

The debt-to-GDP of the UK has come under sharp focus recently, after it exceeded 100% for the very first time since 1963 in the wake of the Covid-19 pandemic.

This represents the type of large-scale deficit financing which is often relied upon to pay for public sector projects and infrastructure spending, and while such investments may stimulate economic activity, they also encourage rising inflation that drives down the demand for the domestic currency from overseas.

The reason for this is simple; as high inflation means that any mounting debts will be serviced and ultimately paid off with cheaper real pounds in the future, causing investors to seek out currencies that have a far lower debt burden.

3. Trading Terms

When referring to the so-called ‘terms of trade’, this is related to a nation’s current accounts and the existing balance of payments.

This also relates directly to import and export numbers. For example, if a nation’s exports rise at a rate that’s greater than that of its imports, it’s terms of trade are thought to have improved markedly. After all, this betrays a greater demand for the country’s exports, creating higher revenues, sustained capital inflows and a rush to buy the associated currency.

The reverse is also true, so nations that see their imports outstrip exports will experience a decline in revenues and see the demand for their domestic currency fall significantly over time.

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