What are the 8 Factors that affect Foreign Exchange Rate?

The Foreign Exchange Rate is defined as the rate at which the currency pairs of a country can be exchanged into the currency pairs of another country. It is also known as Forex rate. The foreign exchange rate may vary on a daily basis due to market fluctuations that totally depend on the demand and supply levels of currency pairs of a country. Thus, it is necessary for the traders to know about the concept of foreign exchange rate in detail before starting trading in the Forex market.

8 Factors that affect Foreign Exchange Rate

The foreign exchange rate defines the financial stability of a country. Therefore, it is one of the most important aspects in terms of determining the economic health of a country. There are a number of factors that are responsible for fluctuations and variations in foreign exchange rates. The vital 8 factors that affect foreign exchange rate are as follows:

Inflation Rate

The inflation rate of a country majorly impacts the foreign exchange rate of that country. A country with a low inflation rate tends to have a stronger currency value than a country with a high inflation rate. So, inflation rate should be maintained in order to increase the currency value of a country.

Interest Rate

The second factor that affects the foreign exchange rate is interest rate. The higher interest rates always attract foreign investors in a country that appreciate the country’s currency value and increase in exchange rates of the country. But if the interest rates are kept higher for a longer period then inflation will start rising in that country. Hence, Central Banks always keep a check on the interest rates on a regular basis to control the inflation in a country.

Recession

Recession in a country badly affects the foreign exchange rate of that country. Recession is directly proportional to the interest rates, so, when recession comes in a country then interest rates also start falling and it decreases the chances of foreign investment in that country. As a result, the currency value starts depreciating that lowers down the foreign exchange rate of the country.

Government Debt

It is defined as a public debt that is owned by the Central government of the country. Most of the countries use large scale deficit bankrolling or borrow money to fund their budgets and economic expansion of the country. But if the government debt rises quicker than the economy then foreign investors are less interested to invest their capital in a country that is under government debt. It may also lead to inflation that adversely affects the foreign exchange rates.

Terms of Trade

It is another major factor that affects foreign rates in both ways like if the terms of a trade are favourable then it affects the exchange rate in a positive way and if the terms of a trade are not favourable then it negatively affects the foreign exchange rate of a country. The terms of trade ratio is somehow linked with export prices to import prices as well as it related with current accounts and balance of payments.

Political Stability

Political stability is a significant factor in terms of affecting the foreign exchange rate. The country with political stability appeals more foreign investors in comparison to a country with less political stability. Stable political stability helps in maintaining a constant currency rate in the country while poor political stability is responsible for depreciating the currency rate.

Country’s Current Account or Balance of Payments

The current account of a country shows the earnings on various foreign investments and balance of different trades. The account keeps a record of all transactions including imports, exports, debts and many more. The shortage of funds or currency in a country’s current account negatively impacts the foreign exchange rate while balance of payments also fluctuate currency rates of its local currency.

Speculation

If there is a speculation about raising the currency value of a country then foreign investors will start demanding more of that currency in order to make good profits in the longer run. It will increase the currency value that affects the foreign exchange rates of that country.

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