The exchange rate is one of the most important determinants of a country's relative level of economic health. It plays a vital role in trade, which is critical to most free market economies. But exchange rates matter on a smaller scale too. They even impact the real return of an investor's portfolio. Here we’ll look at the main factors influencing exchange rates.
Factor 1: Differentials in Inflation. As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. Those countries with higher inflation typically see depreciation in their currency's value in relation to the currencies of their trading partners.
Factor 2: Differentials in Interest Rates. By manipulating interest rates, central banks exert influence over both inflation and exchange rates. Higher interest rates offer lenders a higher return relative to other countries. The impact of higher interest rates is mitigated, however, if a country's inflation is much higher than other countries', or if additional factors serve to drive their currency value down. The opposite relationship exists for decreasing interest rates.
