Understanding how exchange rates work is important for businesses, investors, currency traders and, of course, holidaymakers. But what makes exchange rates rise and fall? FX 101 breaks the world of currency exchange from simple to complex.
Here are 10 factors that affect the exchange rate:
- Supply and demand
Currencies can be bought and sold, such as stocks, bonds or other investments. And like these other investments – and almost anything you can buy or sell – supply and demand affect the price. Supply and demand are one of the most fundamental economic principles, but it can still serve as a good starting point for understanding why exchange rates fluctuate.
Currency is issued by governments. For a currency to retain its value (or even exist), the state before it must be strong. Countries with uncertain futures (due to revolutions, wars or other factors) tend to have much weaker currencies. Currency traders do not want to risk losing their investments and will therefore invest elsewhere. With a small demand for currency, the price falls.
Economic uncertainty is as important as political instability. A currency supported by a stable government is unlikely to be strong when the economy is in the toilet. To make matters worse, a lagging economy can be difficult to attract investors, and without investment the economy will suffer even more. Currency traders know this and will avoid buying a currency supported by a weak economy. Again, this reduces demand and cost.
A strong economy usually leads to a strong currency and a weak economy leads to depreciation. That is why currency traders are so closely watching GDP, employment and other economic indicators.
Low inflation increases the value of the currency, while high inflation usually lowers the value of the currency. If today a chocolate bar costs 2 dollars, but inflation is 2%, the same chocolate bar costs 2.02 dollars a year – it’s inflation. Part of the inflation is good, which means that the economy is growing, but high inflation is usually the result of an increase in the supply of the currency without equal growth in the real value of human assets.
When the Bank of Canada (or any other central bank) raises interest rates, it essentially offers lenders (such as banks) a better return on their investment. High interest rates are attractive to foreign exchange investors because they can receive interest for the currency they bought. Therefore, when the central bank raises interest rates, investors rush to buy their currency, which increases its value and, in turn, stimulates the economy.
But remember that there are no factors influencing currency exchange. Often the country offers very high interest rates, but the value of this currency will continue to decline. Indeed, despite the incentive to take advantage of high interest rates, traders may be wary of economic and political risks or other factors – and therefore refuse to invest.
- Trade balance
The country’s trade balance (i.e., how much a country imports compared to what that country exports) is an important factor in exchange rates. Simply put, the trade balance is the cost of imports minus the value of exports.
When a country has a trade deficit, the cost of its imports exceeds the value of its exports. When the value of exports exceeds the value of imports, there is a trade surplus.
When a country has a trade deficit, it must acquire more foreign exchange than it receives through trade. For example, if Canada had a trade deficit of $100 compared to the United States, it would have to purchase $100 in United States currency to pay for additional goods. Moreover, a country with a trade deficit would also provide other countries with too much of their own currency. The United States now has an additional $100 that it doesn’t need.
Basic supply and demand dictate that the trade deficit will lead to lower exchange rates, and a trade surplus will lead to a stronger exchange rate. If Canada had a trade deficit of $100 against the United States, Canada’s demand for U.S. dollars would be high, but the United States would also have an additional 100 Canadian dollars, so their demand for Canadian dollars would be low because of oversupply.
Debt, especially public debt (i.e. government debt), can also have a significant impact on interest rates. Indeed, large debt often leads to inflation. The reason is simple: when governments have excessive debt, they have a special luxury that we don’t have – they can just print more money.
If the U.S. owes Canada $100, the U.S. government could just run for a coin, turn on the printing presses, and print a new $100 bill. What’s the problem? Well, $100 isn’t big money for the government, no more than $1 million, it’s motivated by $1 billion, but Canada’s public debt exceeds $1 trillion, while the Debt of the United States far exceeds $15 trillion (and grows by $2.34 billion a day). If the country tries to pay its bills by printing money, it will face huge inflation and eventually devalue its currency.
Investors will also be concerned that the country is simply not fulfilling its obligations or, in other words, is unable or unwilling to pay its bills. This is a dangerous situation in which Greece and the euro area are currently located.
- Quantitative easing
The quantitative easing – usually abbreviated to zE – is not easy, but it’s not really that hard. The simplest explanation is that central banks will try to revitalize the economy by giving banks more liquidity (i.e. liquidity) in the hope that they will then lend or invest that money and thus stimulate the economy. To provide this large liquidity, central banks will buy assets from these banks (usually government bonds).
But where do central banks take this extra money? The short answer is they’re creating it. Creating more money (increasing supply) will devalue them, but it will also lead to economic growth – according to the theory.
What is the point of quantitative easing? Central banks will only use quantitative easing during periods of weak growth if they have already exhausted other options (e.g. interest rate cuts).