The Basics of Currency Exchange Rates

Currency exchange rates are rates that signify how much one currency is worth in relation to another currency. This allows you to exchange one set of currency for another without having to argue about their values. Knowing currency exchange rates helps when you are traveling abroad or if you are buying anything in a foreign country. The currency exchange rates shift constantly, sometimes slightly, sometimes fairly drastically. There are a number of factors that account for those shifts. While changes in currency exchange rates are hard to predict, knowing those factors will help you to anticipate the drastic shifts ahead of time.

Understanding Currency Exchange Rates

The factors that influence currency exchange rates are tied to each other. If one factor changes, so do the others--though the way they change differs from country to country. Those factors include inflation, interest rates, trade balance and investor confidence. The only exceptions to this are in countries with pegged currency--currency that is artificially kept at the same value as the other currency. Usually, this currency is a dollar or a euro. While this gives the currency a measure of stability, it has the potential to create financial strain in the long run as government keeps using its funds to keep the value pegged without getting any returns.

Supply and Demand

In order to understand the factors that influence currency exchange rates, you have to understand the concept of supply and demand. For the purposes of currency exchange rates, this refers to the difference between how much currency is available and how many people and/or corporate entities are interested in buying it. If lots of people are interested in buying a certain type of currency and there isn't enough currency for them all, the currency becomes more valuable, which further increases demand. By contrast, if people aren't interested in buying that currency or if there is a sufficient amount of that currency to be available to everyone that wants to buy it, the demand will go down and so will the value. The currency exchange rates shift in inverse proportion to the value. When the value goes up, the currency exchange rates go down (and vice versa).

Inflation

If the supply of money outstrips demand for it, the individual pieces of currency will lose their value. To compensate for the loss of value, the retailers will increase the prices of goods and services. This is known as inflation. The presence of inflation will cause the value of the currency to go down compared to the currencies of other countries.

Interest Rates

The interest rates indicate how much the borrower has to pay to borrow money. As the rates of inflation increase, so do interest rates. This discourages the citizens of that country from taking out loans. This, in turn, makes it harder for the country's entrepreneurs to generate capital, reducing their ability to trade and invest. It also makes the country less attractive to investors from other countries. Together, this slows international trade, decreasing the demand for this country's currency even further. When the interest rates go down, the trends gradually reverse themselves, causing the exchange rates to drop.

Trade Balance

Trade balance occurs when a country imports as much as it exports. This balance is nearly impossible to maintain, but each country tries anyway, causing the balance to shift. If the country exports more than it imports, the demand for its currency will be higher. By the same token, if the country imports more than it exports, the demand for its currency is lower.

Investor Confidence

Investor confidence is a measure of how confident the investors are in the strength and health of their country's economy. If the investors feel that the economy is strong, they are much more likely to buy the country's assets, increasing demand. If they are not confident, they won't buy as much, and the demand will go down.

blog comments powered by Disqus
Scottrade