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Key Factors That Influence Foreign Exchange Rates

Foreign exchange rates are among the most analyzed watched and governmentally manipulated economic measures. If you want to be actively and successfully participate in the foreign exchange market you must acquire the knowledge about the leading factors that cause the fluctuations, variations of the foreign exchange rates and the reasons behind their volatility. Here are some key factors that massively influence the foreign exchange rates of a country.

Inflation Rates

Any kind of change occurring in the market inflation will result in changes in foreign exchange rates. Typically if a country has a lower inflation rate in comparison to another then it shall exhibit an appreciation in the value of its currency, however a country with higher inflation will exhibit depreciation in the value of its currency. High inflation rates are often accompanied by higher interest rates.

Interest Rates

Another key factor that largely impacts the foreign exchange rates is the interest rates. Any changes in the interest rates impact the dollar exchange rate and currency value. Interest rates, inflation rates, and foreign exchange rates are all highly correlated. If there is an increase in the interest rate of a country then it will result in that country’s currency value’s appreciation and vice-versa. Higher interest rates provide higher rates to lenders. This attracts more foreign capital which in turn causes an increase in the foreign exchange rates.

Government Debt

Government debt is the national debt or the public debt owned by the central government. A country with high government debt is less likely to attract foreign capital. This results in inflation. If the market predicts a government debt within a country then its foreign investors are more likely to sell of their bonds in the open market. This results in depreciation in the value of the country’s currency.

Country’ Current Account Balance

The country’s current account balance depicts its balance of trade and its earnings from foreign investments. A current account deficit would mean that a country expenditure on foreign trade is higher than its income and in order to make up the deficit, it is borrowing capital from foreign sources. In simple terms, it means that the country spends more of its own currency on importing products than what it earns through the sale of its exports. The excess demand for foreign currency depreciates the country’s currency value.

Terms of Trade

Terms of trade refers to the ratio between a country’s export prices and import prices. If a country’s exports are higher than that of its imports then the terms of trade of a country would be favorably improved. This will lead to an increase in demand for the country’s currency and appreciation in the country’s currency value. This would mean that the country’s currency value will be higher in comparison to another country’s whose terms of trade are lower.

Political Stability and Economic Performance

A country’s political scenario and economic performance massively impact foreign exchange rates. Foreign investors are attracted to countries that pose a low risk of political and economic instability. Such countries with more economic and political stability draw foreign investment away from countries that pose a high political and economic risk. Increase in foreign capital results in appreciation in the country’s currency value. A country faced with political confusions will lead to a depreciation in the currency rates and a country’s sound financial condition and sound trade policy will positively impact the foreign exchange rates. Political and economic events such as monetary policy changes, financial crisis, elections, wars can massively impact the forex market and reshape a country’s economy.

Employment Data

All countries periodically release their employment rates. The employment rate of a country is a significant indication of the country’s economic condition. A high unemployment rate of a country depicts that the country’s employment rate and its economy is not growing in line with its population growth. This can impact the foreign exchange rates. It can lead to a depreciation in the country’s currency value.


When a country’s currency value is expected to rise the investors tend to demand more of that currency in the hope of making profits in the future. This results in the rise of currency value as a result of increased currency demand. The rise in currency value thus leads to an increase in the foreign exchange rate.

All the above factors impact the foreign exchange rates at any given point of time in an economy. If you plan to indulge in active foreign exchange trading then the knowledge of these key crucial factors is only imperative to determine the currency value at any given point of time and to make prudent trading decisions. The knowledge of these factors can enhance your chances of making more money as a currency trader in the foreign exchange market.

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About the Author: Praveen Unnikrishnan

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