Knowing how currency exchange rates work is essential for businesses, investors, currency traders and, of course, vacationers. But what makes currency exchange rates to swing up and down?
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Here are seven factors that affect currency exchange rates:
1. Supply and Demand
Currency can be purchased and traded, just like stocks, bonds, or other investments. And just like these other investments - and almost anything else you can buy or sell - supply and demand impacts price. Supply and demand is one of the several basic economic principles but can work as a good starting point to understand why currency exchange rates vary.
2. Political Stability
Governments issue currency. For money to retain its value, the government which backs it has to be reliable. Countries with possible futures usually have much weaker money. Currency traders don't want to risk wasting their investment and so will spend elsewhere. With little demand for the money, the price drops.
3. Economic Strength
Economic uncertainty is as significant of a factor as political instability. A currency supported by a stable government isn't likely to be active. More serious, a lagging economy may have a hard time dragging investors, and without investment, the market will bear yet more. Currency merchants know this so they will withdraw buying a currency backed by a shaky economy. Again, this creates interest and value to fall.
A strong economy usually leads to a stable currency, while a floundering market will result in a fall in value. This is why GDP, employment levels and other economic signs are observed so strictly by currency traders.
4. Inflation
Underinflation improves the value of a currency, whereas the high rise usually makes the value of a currency drop. If a candy bar costs $3 today, but there is 2% inflation then that same candy bar will cost $3.02 in a year - that's inflation. Some increase is excellent, and it means that the economy is improving but, high rise is usually the result of an improvement in the supply of currency without an equal growth in the real value of a country's assets.
Think of it like this, and if there is more of something, then it's ordinarily worthless - that's why we spend so much for rare autographs and collectors' items. With more currency in rotation, the value of that currency will drop. Inflation results from a developing economy, this is why China, India and other developing economies typically have enormous growth and above inflation - and their currencies are worthless. Zimbabwe experienced hyperinflation throughout the late 1990s and 2000s reaching as high as 79.6 billion per cent in 2008, presenting the money near cheap.
5. Interest rates
When the Bank of Canada (or any other central bank) increases interest rates, it's offering lenders (like banks) a more significant return on investment. Substantial interest rates are attractive to currency investors because they can get interested in the currency that they have bought. So if a central bank increases interest rates investors to flock to obtain their money which increases the value of that currency and, in turn, boosts the economy.
6. Trade Balance
A country's balance of trade is an essential factor behind exchange rates. Put, the balance of business is the number of imports minus the value of exports.
If a country has a trade debt, the value of its imports is higher than the value of its exports. A trade surplus occurs when the cost of commodities exceeds the value of imports.
When a country has a trade deficit, it needs to get more foreign currency than it takes through trade.
7. Unemployment
Unemployment levels in a state change almost every aspect of its economic performance, including exchange rates. Unemployed people have less money to spend, and in times of real financial hardship, high levels of unemployment will encourage employed people to start saving, just in case they wind up unemployed too. Unemployment is a significant sign of an economy's health. To increase employment, a country must promote the economy as a whole. To do this, central banks will reduce exchange rates and even resort to more drastic measures like quantitative easing, both of which can negatively impact the value of a currency. This is why currency traders pay such close attention to employment statistics.
