We’re all aware that currencies move up and down relative to each other. Just ask any holiday maker how a difference in the exchange rate can make them feel richer or poorer when they travel abroad. For example, if the Dollar rises in value against the Indian rupees, anyone on a shopping in India can buy more with their Dollars. |
Exchange rates specify how much one currency is worth compared to another. For example, an exchange rate of $1 to the Indian Rs. 54.41 means that Rs. 54.41 you have will be worth $1 when you go to America. In addition to the official exchange rate, you might find that you’re charged commission when you want to change some currency; this is because exchange bureaus want to make a profit on their dealings.
Supply and demand
Exchange rate will change whenever the value of currency change. A currency will usually become more valuable whenever demand for it is greater than the supply & it will become less valuable whenever demand is less than supply. This does not mean that people no longer want money; it just means that they prefer to hold their wealth in some other form, possibly another currency. Increased demand for a currency is due to either an increased ‘transaction demand’ for money, or an increased ‘speculative demand’ for money.
The transaction demand for money is related to the country’s level of business activity, GDP and employment levels. For example, the more people that are out of work, the less the public as a whole will spend on goods and services, resulting in a drop in the value of a currency. Central banks (such as RBI) will adjust the supply of money to accommodate changes in demand due to business transactions. The speculative demand for money is much harder for a central bank to accommodate, but it will try to do this by adjusting interest rates. Investors will choose to buy a currency if the return - or interest rate - is high enough. The higher a country’s interest rates, the greater the demand for that currency.
In choosing what type of asset to hold, people are also concerned that the asset will retain its value in the future. Most people will not be interested in a currency if they think it will devalue. A currency will tend to lose value, relative to other currencies, if the country’s level of inflation is high, if the country’s GDP is expected to decline, or if a country is troubled by political uncertainty.
As a result of these fluctuations it is possible for anyone to make money trading currencies.
Top 5 Factors Affecting Exchange Rates
Exchange rates change by the second. Understand the dynamics that affect them. Currency changes affect you, whether you are actively trading in the foreign exchange market, planning your next vacation, shopping online for goods from another country—or just buying food and staples imported from abroad. Like any commodity, the value of a currency rises and falls in response to the forces of supply and demand. Everyone needs to spend, and consumer spending directly affects the money supply (and vice versa). The supply and demand of a country’s money is reflected in its foreign exchange rate.
When a country’s economy falters, consumer spending declines and trading sentiment for its currency turns sour, leading to a decline in that country’s currency against other currencies with stronger economies. On the other hand, a booming economy will lift the value of its currency, if there is no government intervention to restrain it. Consumer spending is influenced by a number of factors: the price of goods and services (inflation), employment, interest rates, government initiatives, and so on. Here are some economic factors you can follow to identify economic trends and their effect on currencies.
1. Interest Rates
“Benchmark” interest rates from central banks influence the retail rates financial institutions charge customers to borrow money. For instance, if the economy is under-performing, central banks may lower interest rates to make it cheaper to borrow; this often boosts consumer spending, which may help expand the economy. To slow the rate of inflation in an overheated economy, central banks raise the benchmark so borrowing is more expensive.
Interest rates are of particular concern to investors seeking a balance between yield returns and safety of funds. When interest rates go up, so do yields for assets denominated in that currency; this leads to increased demand by investors and causes an increase in the value of the currency in question. If interest rates go down, this may lead to a flight from that currency to another.
2. Employment Outlook
Employment levels have an immediate impact on economic growth. As unemployment increases, consumer spending falls because jobless workers have less money to spend on non-essentials. Those still employed worry for the future and also tend to reduce spending and save more of their income.
An increase in unemployment signals a slowdown in the economy and possible devaluation of a country’s currency because of declining confidence and lower demand. If demand continues to decline, the currency supply builds and further exchange rate depreciation is likely. One of the most anticipated employment reports is the U.S. Non-Farm Payroll (NFP), a reliable indicator of U.S. employment issued the first Friday of every month.
3. Economic Growth Expectations
To meet the needs of a growing population, an economy must expand. However, if growth occurs too rapidly, price increases will outpace wage advances so that even if workers earn more on average, their actual buying power decreases. Most countries target economic growth at a rate of about 2% per year. With higher growth comes higher inflation, and in this situation central banks typically raise interest rates to increase the cost of borrowing in an attempt to slow spending within the economy. A change in interest rates may signal a change in currency rates. Deflation is the opposite of inflation; it occurs during times of recession and is a sign of economic stagnation. Central banks often lower interest rates to boost consumer spending in hopes of reversing this trend.
4. Trade Balance
A country’s balance of trade is the total value of its exports, minus the total value of its imports. If this number is positive, the country is said to have a favorable balance of trade. If the difference is negative, the country has a trade gap, or trade deficit.
Trade balance impacts supply and demand for a currency. When a country has a trade surplus, demand for its currency increases because foreign buyers must exchange more of their home currency in order to buy its goods. A trade deficit, on the other hand, increases the supply of a country’s currency and could lead to devaluation if supply greatly exceeds demand.
5. Central Bank Actions
With interest rates in several major economies already very low (and set to stay that way for the time being), central bank and government officials are now resorting to other, less commonly used measures to directly intervene in the market and influence economic growth.
For example, quantitative easing is being used to increase the money supply within an economy. It involves the purchase of government bonds and other assets from financial institutions to provide the banking system with additional liquidity. Quantitative easing is considered a last resort when the more typical response—lowering interest rates—fails to boost the economy. It comes with some risk: increasing the supply of a currency could result in a devaluation of the currency.
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