Factors That Affect Currency Prices
By Dale Gillham | Published 21 October 2018
We are reminded in the media every day that our dollar is either going up or down against other currencies, however, very few understand what factors affect currency prices or how their they may affect the stock market, so let me explain.
What determines currency prices?
Currency prices are simply determined by supply and demand or the amount of buying and selling of various currencies in the Foreign Exchange market or FX or Forex market, as it is known. Like a stock trading on the stock market, the price of a currency will fluctuate throughout the day on the FX market with the forces of supply and demand determining whether the currency rises or falls.
When there are more buyers the currency will rise and when there is more seller’s the currency will fall. But what drives this supply and demand?
Five factors that affect currency prices
Factor 1: Interest rates
Firstly, rises in interest rates in a country will result in that currency appreciating in value. It does this because a higher interest rate provides better incentives for individuals to invest in cash. A rise in interest rates will also attract more foreign capital into the country and as a result demand for the currency increases, which therefore will see the currency rise in value.
Lower interest rates, on the other hand, means lower returns on cash investments making it less attractive. This can result in a currency falling in value as investors move cash away from a country into other markets.
Factor 2: Inflation
The second factor is Inflation: countries that have lower levels of inflation cause a currency to appreciate in value, as there is less money being injected into the economy. When inflation is low the cost of goods and services will rise quite slowly.
The opposite occurs when inflation is high, as the price of goods and services will rise rapidly. Increasing levels of inflation usually results in depreciation to a currencies value and is often accompanied by higher interest rates to account for the extra money being brought into the economy.
Factor 3: Balance of payments and debt
The third factor that will impact currency values is a country’s balance of payments and debt between imports and exports, and debt and foreign investments. If a country is spending more on imports than it gets from exporting goods and services, more money is going out of the economy which often results in the currency depreciating in value.
In addition, countries with higher amounts of debt are less likely to obtain foreign capital which means that they will have to inject more money into the economy by raising inflation levels.
Factor 4: Political stability
The fourth factor is political stability. A country's political stability largely affects currency prices. A government with a stable economy is less risky for investors and ultimately a more desirable place to invest funds.
Governments with strong economic and trade policies remove any doubt from the market and ultimately the strength of the currency. Instability in an economy, on the other hand, will likely see a currency depreciate as the risk of investing funds in that country becomes higher.
Factor 5: Commodity prices
The final factor that affects currencies is commodity prices. Countries, such as Australia, that are large exporters of raw materials are affected by movements in commodity prices. When commodity prices rise, countries who export heavily are likely to see their currency rise as they are getting more money in exchange for goods. The opposite is true of countries who are large importers of commodities, such as China. Higher import costs means the cost of manufacturing becomes higher and profit margins are squeezed.
So there you have it, the five factors affecting currency prices. So now when you watch the news you will be able to have an appreciation of what might be happening in a particular country and whether it is good or bad for their currency.
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