What Factors Determine Currency Exchange Rates?

Currency exchange rates signify how much a currency is worth in relation to another. For example, a currency exchange rate of the Japanese yen to a U. S. dollar is how many yen equal the value of one dollar. Currency exchange rates are important when you have to spend your money in another country. The currency exchange rates shift constantly, though not always drastically. This is due to a number of factors. While there is no way anyone can truly predict how the currency exchange rate will behave 100 percent of the time, knowing those factors will make you much more prepared for the fluctuations.

Supply and Demand

In order to understand the factors behind the shifts in currency exchange rates, one must first understand supply in demand. For the purposes of currency exchange, the term "supply and demand" refers to the difference between how much currency is available in the international markets and how many parties are interested in buying it. If the demand for currency is high, the value of the currency will go up and the currency exchange rates will go down. If the demand is low, the value of the currency will drop and the currency exchange rate will go up.

There are several factors that influence supply and demand. They include inflation, interest rates, trade balance and investor confidence. Because each country has different economic conditions, the roles these factors play in the way currency exchange rates shift vary. The factors can change fairly rapidly, and the change in one factor can affect the others.

Inflation

Inflation occurs when the prices of goods and services increase. It occurs when the supply of currency outstrips demand, causing individual pieces of currency to lose value. If one currency loses value, while another country's currency retains the same value, the exchange rates will rise. If the demand for the country's currency picks up and its value rises, the exchange rates will decrease.

Interest Rates

The interest rates indicate how much the borrower has to pay to borrow money. They tend to correspond directly to the rates of inflation. As the rates of inflation increase, so do interest rates. This, in turn, causes the decrease in the number of people who are willing to take out loans. This 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. All those factors slow international trade, decreasing the demand for currency even further. When the interest rates go down, the trends gradually reverse themselves, and the exchange rates go down as well.

Trade Balance

Trade balance is the balance between how much a country imports and how much it exports. Ideally, the exports and imports would be equal, and each country constantly tries to achieve that balance, causing the exchange rates to fluctuate. 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 would be much more likely to buy the country's assets, increasing their value while driving off demand. If they are not confident, they won't buy as much, and the demand will go down.

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