The value of a currency depends on crucial factors such as inflation, employment, imports and exports, trade deficit, performance of equity markets, foreign exchange reserves, geopolitical conditions, etc.
However, there are actually four main factors that need to be taken into consideration before weighing the strength of a currency. Below are the factors that affect the value of currencies in different countries. These factors are universal and stand true for any country in the world.
1. Interest Rates
A country’s interest rate is a major factor that determines the strength or weakness of a country’s currency. In simple words, the interest rate is the cost amount that needs to be paid on borrowing money. The change in the interest rate level is determined by the country’s central bank. It is done to revive or slow down the economy.
As the interest rate of a particular currency rises, so does the demand. Similarly, when the interest rates go down, so does the demand for that currency. Because of the additional rate of return on currency exchange, investors remain interested in buying currencies which have higher interest rates.
When you buy a currency with a higher interest rate instead of the lower interest rate currency, you get the benefit of the interest rate differential (IFD). Thus, you now know why currencies with higher interest rates are much more attractive than those with low interest rates.
Inflation simply means the increase in the prices of goods and services. As the price of a product rises, it could mean that there is a high demand for that product. While this may not seem good for the local consumers, inflation in moderate levels is actually good for the economy of a country.
As a matter of fact, most central banks set a target inflation rate of around 2 percent a year. In the event of too much inflation in a country, the central bank tries to control the situation by increasing interest rates. As explained in the previous point, higher interest rates attract more investors. The point here is that with the rise in inflation, investors start expecting that interest rates will rise too.
While inflation is good for the economy of a nation, there are certain ill effects of inflation that you need to know about. Rising inflation is good as long as the economists and decision makers of a country know how to deal with it. With the right decisions taken by the Central Bank of a country, inflation is certainly not bad news.
3. Economic Growth
The strength of a country’s currency is very much dependent on the strength of the country’s economy. The economic growth of a country can be traced when you see the growth in demand for products and services and the rise in investments. With better economic growth, inflation rates rise. This leads to expectations for higher interest rates. With higher interest rates, foreign investments come in. This leads to the strengthening of a country’s currency.
4. Current Account Balance
Current balance is another major factor that affects the value of your currency. In simple terms, the current account balance is the total amount of goods, services, income and currency transfers of a nation with the rest of the world. Having a positive current balance means that a country lends more to the world than it borrows. Having a deficit current balance means that a country borrows more than it lends.
A country which sees a high demand for its goods, exports more than it imports and thereby increases the value of its currency.
Understanding economics and currency forecasting can be quite a daunting task. Currency price changes are hard to forecast. However, understanding the basics of currency trends is not that difficult. With some research and exploration of the subjects, you can go a long way and gain expertise in your field.
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