Factors that Influence Foreign Exchange Rates

Currency (or money) has multiple purposes, including being used as a convenient exchange medium for purchasing products and services. Each nation has a monopoly that gives its government the exclusive right to print its own money. There is one accepted currency within national borders for buying and selling merchandise.

Outside of the country, a national currency cannot be used for purchasing products and services. Thus, foreign exchange must occur, which enables each country to buy the currencies of other nations, so they can purchase the products and services of said nation. Trade "between" countries can occur due to foreign currency exchange.

When an Australian consumer wants to buy a Japanese Toyota truck, there is an exchange of Australian Dollars (AUD) and Japanese Yen (JPY) somewhere along the purchasing process. The "Foreign Exchange Rate" is the price of a specific currency vis-a-vis another currency - the number of currency units traded by one country for the number of currency units of another country. For example, 100 AUD are exchanged for 8185 JPY; that is the foreign currency exchange rate for that currency pair.

Currencies are supposed to represent the total production capacity and value of goods and services of a country. Paired foreign exchange rates can change for any of the three following reasons: 1.) Country A's currency changes value, 2.) Country B's currency changes value, or 3.) the relationship between the two countries changes. Based on these exchange rates, you can figure out which currency is more valuable; the one that purchase more currency units of the other currency is more valuable (in the example above, the AUD is more valuable than the JPY).

The following is a list of factors that influence foreign exchange rates:

  • Balance of trade - Demand for nation's goods and services
  • Economic stability - Employment, growth, sales and wage figures
  • Government fiscal policies - Spending on programs
  • Government monetary policies - Printing money and interest rates
  • Inflation - Erodes purchasing power
  • International capital flow - Powerful financial institutions, banks, and government purchases
  • International trade - Flow of goods and services
  • Investor interest - Legitimate demand
  • National debt - Money spent servicing the debt is taken away from more productive purposes
  • Other currencies traded - One currency's value can affect another currency's value
  • Political stability - Can government continue to pay bills and provide services?
  • Productivity - Competitive industry efficiency
  • Speculative trading - Betting on rise or drop in value
  • Unemployment - Lowered purchasing power.

Government Influence

Since the government has a monopoly over printing money, it has the primary influence on the value of its currency. Government spending on programs that serve the population tend to "crowd out" other investments, reducing the growth rate that a nation can achieve. Some government expenditures enable businesses to increase profits - infrastructure, health, and education - while others can be economically destructive - pointless overregulation.

Sovereign risk is the danger of a government failing to manage its political-economy. When the political stability of a nation is threatened due to revolution or war, investors calculate the potential for losing their investments. Holding the currency of a defunct nation is pointless, unless you are a collector. Most new governments will "pick-and-choose" which debt obligations of their predecessors that they will honor.

National interest rates help determine the availability and value of money in a country. Investors calculate whether they are likely to receive the best rates of return based on prevailing interest rates.

The "Debt-to-GDP" ratio is an important calculation that determines the ability of a nation to repay its debt. Although, few nations go completely bankrupt, they do need to pay off their debts somehow. When faced with high levels of national debt, some governments devalue their own currency in order to pay the debt off.

Economic Industrial Capacity

The industrial capacity of a nation to produce merchandise and services will influence its foreign exchange rates. Generally, nations with higher production capacity have higher valued currencies. The main exception to this rule is when a nation has a high national debt or trade deficit leading to high inflation.

+ A strong, rising currency suggests that the national economy is strong.
+ A weak, declining currency suggests that the national economy is weak.

Nations trade with one another in order to acquire products and services that are cheaper or not available in their home country. This rule of international trade is taught in economics as "comparative advantage." When a nation's "balance of trade" has more imports than exports, then the account is running a deficit.

Multinational corporations must exchange foreign currency for their products and services that are purchased in other countries. These companies need different currencies to pay for raw materials, finished products, or salaries.

Investor Trading Demand

The demand of investors for a nation's currency affects its value. Besides multinational corporations, other key currency traders include individuals, securities dealers, institutions, banks, and governments.

There is a difference between legitimate investment and speculation in theory; but in practice, it is very difficult to separate the two.

Legitimate foreign currency exchange is used for an actual purpose where the currency will be used to buy something tangible. Some businesses purchase currency securities contracts as "hedges" against future changes.

Speculation occurs as experienced traders make educated guesses as to whether a currency will become more or less valuable. Some experienced "arbitrage" traders are able to make money by comparing price differences in different foreign exchange currency markets.

Australian Dollar (AUD) is Ranked Fifth for Foreign Exchange Trading

Australian dollars (AUD) are traded on foreign exchanges for the purchase of goods and services produced by Australians. Australia has an important regional position. Thus, the Australian Dollar (AUD) is in the top five of currencies traded worldwide, usually behind the United States Dollar (USD), Euro (EUR), Japanese Yen (JPY) and British Pound (GBP). Currencies are traded in pairs. Usually, two foreign exchange rates are quoted - one for buying and one for selling.

The United States dollar has a prominent position as a link between different currencies - rather than trading directly between Country A or Country B, Country A might exchange its currency for the USD, which is then used to purchase the currency of Country B. This increases the demand for USD.

The Australian Dollar (AUD) serves the same purpose on a regional basis.

Certain more developed nations are seen as safe havens during difficult economic times.

Some countries peg their currencies to more stable currencies to provide stability in economic markets. Many third-world, developing nations use version of the Franc, Pound, and Dollar for their currencies to demonstrate fiscal stability.

World Wide Web has Increased Foreign Exchange Trading Options

Nowadays, there are huge trading volumes for foreign currency exchange because so many players are involved worldwide 24/7/365. Profit margins are low, so leverage is used to increase profits. Capital flows have become more mobile with the Internet.

National currencies with the highest growth potential are the beneficiaries of positive capital flow.

Floating versus Pegged Currencies

After World War II, the United States of America established the dollar as the primary currency for international trade. Due to American debt problems, it created a system of "floating currency" values based on market supply and demand. Even within this "market-determined" currency system, most currencies are initially "pegged" to the American dollar.

To different degrees, governments "peg" their own currencies by making an official government declaration as to its value. Nations are wary of allowing very wealthy currency speculators to engage in market manipulation that would inflict serious damage on their real national economies.

Generally, developing countries have more fixed currencies due to lower volumes of trade.

Foreign Exchange Rate Theories

Various foreign exchange rate theories have been advanced - "Purchasing Power Parity," "Balance of Payments," and "Monetary Policy" - but all share the concept of a balance between economic elements.

Credit Crunch of 2008 Shows How Factors Affect Foreign Exchange Rates

In 2008, the European-American bloc of countries ran into similar economic problems due to their high debts, expensive welfare systems, and real estate speculation. The change in foreign exchange rates for their currencies is instructive. While the Australian economy is not larger than the American economy, the AUD has become more valuable than the USD at different times.