What Affects Currency Exchange Rates? | Inflation & Deflation [Prep]

We can determine a country’s economic success through its foreign exchange rates. Exchange rates are the rate at which one local currency can be converted into another.

Understanding how foreign currency exchange rates work can help you in all sorts of ways, like helping you invest in forex as an alternative investment for an increasingly volatile stock market, like helping you decide whether or not you should do business with a company in another country, and like helping you decide which country’s accommodations and attractions will give you the best value for your money when you visit on your next vacation.

5 FACTORS AFFECTING HISTORICAL EXCHANGE RATES

Many factors affect money exchange rates. It can, for example, be a recession, inflation rates, government debt,  terms of trade, and political stability.

1. How a recession affects foreign currency exchange rates: When a country is experiencing a recession, interest rates will fall, which decreases its ability to attract foreign capital. Since its local currency is weaker when compared to other countries, it’s exchange rate is lower.
2. How inflation affects foreign exchange rates: When a country has a lower inflation rate compared to other countries, its currency value increases. Pricing of goods and services increase at a slower pace while currency value increases.  The opposite happens when a country has high inflation rates. As the price of goods and services get more expensive, the currency’s value decreases.
3. How government debt affects historical exchange rates: When a country has high government debt, it will find it difficult to get foreign capital. This, in turn, increases inflation. Because foreign investors sell their bonds, the exchange rate falls.
4. How terms of trade affect money exchange rates: When a country improves its terms of trade, it’s export prices will increase at a higher rate compared to its import prices. This creates higher revenue and a higher demand for its currency. Because of an increase in the value of its currency, the exchange rate appreciates.
5. How political stability affects current exchange rates: When a country enjoys political stability, it usually has better economic performance. The fewer its conflicts with other countries or the less its internal dissensions, the more likely it is to attract tourism and foreign investments. Because of this external and internal harmony, it’s domestic currency appreciates. Conversely, a country that has political confusion and a military entangled in aggressive maneuvers with other countries, the more likely it is to experience unstable finances and trade. Consequently, its current exchange rates noticeably depreciate.

HOW CURRENCY EXCHANGE RATES WORK

Foreign exchange rates and cryptocurrency exchange rates are usually tied to the US dollar. A country’s central bank will hold exchange rates dollars to determine how much their own currency is worth. It may either increase or decrease the supply of dollars to change the value.

For instance, the Saudi Arabian riyal has a fixed exchange rate. To keep it fixed, they occasionally have to adjust its value in relation to the US dollar. So, if the value of the riyal should fall, the central bank would sell a portion of its dollars in exchange for riyals. This reduces the supply of riyals in Saudi Arabia. As the value of riyals increases, the value of dollars decreases.

Since figuring out how international exchange rates are determined, calculated, and change is an extremely complex topic, let’s approach it by answering some frequently asked questions.

1.  How Currency Exchange Rates Are Calculated

An exchange rate is the measure of one currency in relation to another. Conversion requirements are calculated based on how two currencies paired in relation to each other.

The order in which the pair is listed makes a big difference. For instance, pairing the United States dollar and the Canadian dollar will result in a different calculation compared to pairing the Canadian dollar with the United States dollar. The math is different because the first currency in a pair is taken as one unit and the second figure is how much of the second currency is needed to buy a unit of the first.

While you can always use a currency converter to figure out US dollar exchange rates, cryptocurrency exchange rates, or exchange rates for the euro to the dollar, here are the three basic steps you would need to take to manually calculate the difference in the real exchange rate between two currencies:

1. Find the difference between two types of exchange rates. For instance, if one currency is 1.12 and the second is 1.0950, then 1.12 minus 1.0950 is 0.025.
2. Divide your answer by the market exchange rate. For instance, 0.025 divided by 1.0950 (the second currency) is 0.023
3. Calculate the percentage of the discrepancy. For instance, 0.023 times 100 is a 2.23% markup.

2. How Are Exchange Rates Today Generally Set?

When exchange rates float currencies, the value of a certain currency can change in response to Forex mechanisms.

The opposite of a floating currency is a fixed currency. When a currency is fixed, it’s value is tied to something. It might, for instance, be tied to the value of another currency, or it might be tied to the value of material goods, or it might be tied to the value of a currency basket.

Each country examines its unique economic situation to determine whether it should use a fixed or floating exchange rate.

3. What Happens When Foreign Exchange Rates Change?

When currency exchange rates change, the way it will be exchanged with another currency also changes. The value of the currency is now re-evaluated in relation to the value of the other currency.

4. What Happens When Exchange Rates Are Flexible?

Flexible exchange rates are often determined by the forces of supply and demand. This allows for market fluctuations and can also be impacted by a trade deficit and other barriers to an open market.

5. What Happens When Exchange Rates Are Set by Government Decree?

When fixed exchange rates are set by government decree, then the results are often unpredictable because there are so many factors at play like currency valuation, the economic relationships with other countries, the behavior of currency speculators, and the differences in exchange rates. For instance, in 1982 after Mexico decreed the exchange rate for the Mexican peso, no one could have predicted that the currency would collapse.

6. When Are Exchange Rates the Best?

Since foreign exchange rates can be influenced by many factors, how can you determine when currency exchange rates are the best? A general rule of thumb is that the higher the exchange rate, the better it will be for you. These rates work in your favor because you’ll be able to acquire more of the foreign money you’re purchasing.

7. When Are Exchange Rates Determined?

Many factors determine the exchange rate. Consequently, the exchange rate is relative because all the factors are based on the trading relationship between the two countries. What’s more, not only is there no definite order of factors to help evaluate a monetary situation, but experts will also debate the validity of the identified factors.

HOW EXCHANGE RATES AFFECT INVESTMENTS

Exchange rates will affect your investments. Let’s use the Iraqi Dinar and Vietnamese Dong as examples.

If you invest in the Iraqi dinar or the Vietnamese dong, you are speculating that the value of these currencies will rise. You believe that in the future, other investors will want more of the currency, too. By buying these currencies now, while the prices are still low, you’ll benefit by selling them at a higher price when these currencies increase in value and their exchange rate appreciates.

Your beliefs are not based on hope or conjecture but are grounded in observable facts.  You believe that you will make a profit in the future if you exchange your domicile currency for these exotic currencies because of sound economic forecasting.

With the Iraqi dinar, your positive forecasts will be based on the fact that the currency is set to revalue because Iraq’s infrastructure is being rebuilt at a rapid rate based on the government’s five-year reconstruction plan. As a result, the economy will flourish again.

With the Vietnamese dong, your positive forecasts will be based on the fact that the currency is set to revalue because the country’s economy has done so well that it’s now the world’s 47^th largest economy. Moreover, this international ranking isn’t just a rough estimation but grounded in solid numbers—specifically the gross domestic product (GDP) and the purchasing power parity (PPP). Many economists attribute this rapid progress to a strong domestic consumption of goods and services.

HOW EXCHANGE RATES AFFECT OTHER ASPECTS OF LIFE

Let’s now take a brief look at how exchange rates can affect other areas of our lives – business, inflation, tourism, the economy, exports, and domestic and international trade.

1. How Exchange Rates Affect Businesses

When two companies from different countries, say, one in Europe and one in the US, exchange products and services, their business transactions are affected by their major currencies. Any changes in the euro to dollar exchange rates could lead to profits or losses for these businesses.

2. How Exchange Rates Affect Inflation

An increase in a country’s interest rate will cause a corresponding increase in its currency. More interest rates provide lenders with higher rates. This attracts more foreign capital and an appreciation in exchange rates.

3. How Exchange Rates Affect Tourism

People visiting one country from another country will be affected by the exchange rate between the two countries. If the exchange rate is favorable, they will stay longer and spend more money on goods and services. If it’s unfavorable, they will find everything expensive, curb their spending, and maybe even shorten their stay.

4. How Exchange Rates Affect the Economy

When there is an appreciation in exchange rates, it will cause a slower growth in an economy because there will be a drop in a country’s net exports and an increase in a demand for imports. Consequently, a higher exchange rate will have a negative multiplier impact on a country’s economy. 

5. How Exchange Rates Affect Exports

A weak domestic currency will encourage exporting and discourage imports. Exports will seem profitable while imports will appear expensive.  The opposite happens when a country has a strong domestic currency. Then exports are hampered while imports are considered cheaper.

6. How Exchange Rates Affect Domestic and International Trade

The exchange rate will influence a country’s trade surplus or deficit. This will affect government decisions on whether it should encourage exports or imports.

THE BOTTOM LINE

You now understand how a country’s exchange rate is an important a factor to consider. It’s as important as inflation and interest rates in determining a country’s economic health. Currency exchange rates play an essential role in a nation’s level of trade, a critical aspect of every free market economy.

You can benefit from a knowledge of foreign exchange market rates by speculating on undervalued currencies, observing that since a country is experiencing renewed economic growth their currency is poised for revaluation. By purchasing a currency at a low rate now compared to the US dollar, you can profit by selling the currency after it’s value has increased due to economic renewal. You can also use this knowledge of foreign exchange rates to decide which countries you should visit as a tourist or which foreign companies you should do business with.

If you’d like to buy a position in Iraqi Dinar or the Vietnamese Dong, or for that matter, any other speculative currencies, or if you’d like to get a better understanding of cryptocurrency exchange rates, dollar exchange rates, or euro exchange rates, we can help you here at Treasury Vault