The 6 Factors That Influence Exchange Rates

Every day, close to $5 trillion of currency gets exchanged on global markets.

It’s a market that’s running continuously for 24 hours per weekday around the world – and transactions can happen using different mechanisms, such as spot transactions, outright forwards, foreign exchange swaps, currency swaps, or the use of other types of options.

But what fuels changes in this extremely liquid and busy market, and why are the exchange rates between countries constantly in flux?

Key Market Factors

Today’s infographic comes to us from Hiwayfx and it highlights six of the major factors that can impact currency exchange rates.

As with many things in macroeconomics, it’s important to note that many of these factors are related and can feed off each other.

For example, a high rate of inflation can lead to central bank intervention, such as raising interest rates and buying or selling domestic currency. This could lead to an increase in government debt, and so on.

What Influences Exchange Rates?

Here are the six factors summed up again:

1. Government Intervention: Central banks can influence rates by buying or selling the domestic currency.

2. Inflation: Countries with consistently high inflation rates tend to have lower currency values. This is because purchasing value decreases relative to other countries.

3. Interest Rates: A rise in interest rates in a country can offer investors a higher rate of return than other countries. As a result, the currency can appreciate relative to other countries.

4. Current Account Deficits: If a country has a current account deficit, it means that it’s spending more than it’s earning in foreign trade. To make up this deficit, countries may borrow capital from other external sources, which in turn will help make the domestic currency depreciate.

5. Government Debt: Countries with high amounts of debt are less attractive to foreign investors due to the chance of default as well as possible high inflation rates. This can decrease the currency’s value.

6. Speculation: Most trades in the forex markets are speculative trades, which means that sentiment and momentum can play big roles in market activity. Even if the fundamentals don’t align, the market for a currency can continue soaring or depreciating if traders and governments perceive it should.

For a related topic, see a map of the countries with the most foreign currency reserves.