In the finance industry, the definition of exchange rate has been regularly repeated in many decades because of the increasing demand for currency exchange and trade among the countries.
So, what is meant by exchange rate and what affects the exchange rate? Let’s find out in the following article.
What is meant by exchange rate?
An exchange rate is a rate at which a currency will be exchanged for another one.
In other words, an exchange rate will tell you about your currency value in another country’s currency. It also plays an important role in determining trade and capital flow dynamics.
For example, in June of 2022, 1 Euro was equivalent to 1.05 U.S. dollars, and 1 U.S. dollar was equivalent to 0.95 euro.
What is meant by exchange rate?
In general, exchange rates greatly influence several aspects of life: the cost of groceries, interest rates or even employment opportunities.
Changes in rates can happen hourly or daily in small or big volumes. Countries can also have a strong or weak currency.
What affects the exchange rate?
There are 7 main factors that affect the changing exchange rates.
1. Interest and inflation rates
People often borrow and spend more than normal rates when the interest rates go low. This leads to an increase in costs. When inflation occurs, the currency will devalue.
These rates are direct factors of the current economic performance. They can affect the decisions of investors and traders around the world.
An increase in interest rate is followed by an increase in the value of the local currency. This happens because the economy is growing too quickly and central banks are trying to slow inflation.
2. Current account deficits
The current account is the balance of trade between a country and its partners. It describes the value difference between the goods and services with other countries.
If a country purchases more than it sells then the balance of trade deficits. It influences the exchange rate because a country needs more foreign capital, thus lowering the demands for local currency.
3. Government debt
A country with a big amount of government debt won’t attract more foreign investment and acquire more foreign funds. This can lead to inflation.
It can happen when existing foreign investors sell their bonds if they predict an increase in government debts. This results in an oversupply of the local currency, then decreasing its value.
4. Terms of trade
Terms of trade is the ratio of the export prices to its import prices. When the export prices of a country rise greater than its import prices, the terms of trade will be improved.
In turn, it results in higher revenue, higher demand for the country’s currency, and there is an increase in currency value.
5. Economic performance
Political stability has a great effect on the economic performance of a country. If a country has a stable political environment, it will draw more and more foreign investments.
If there is an increase in foreign capital, this will result in appreciation in domestic currency value. The stability also affects the financial and trade policy, thus getting rid of any uncertainty in the currency value.
6. Economic recession
During an economic recession, a country’s interest rates tend to fall, decreasing its opportunities to gain foreign capital.
In turn, this weakens the currency of the country and the exchange rate.
The investors long for more of a country’s currency when its value is expected to rise to make a profit in the future.
As a result, the value of the currency rises because of its increased demand. This also led to a rise in the exchange rate.