Foreign currency plays a vital role in the global economy, as it is the medium of money exchanges between two or more countries, international trade, and transfer of the funds released by the Governments of international banks and global fund houses.

Foreign exchange rates do not remain the same all the time, they keep changing or fluctuating because various forces work behind the demand and supply of currency of any country. And taking advantage of this price change in the currency market, traders in the forex market are buying or selling the currencies and earning significant amounts of money.

Though, the currency of most developed and big nations is mostly used for trading in the forex market. But all the country have their currency and are influenced by various factors. As there is no particular reason behind the change in foreign currency exchange rate, hence, today we will learn about all the factors affecting the exchange rate.

What is a Foreign Currency Exchange Rate?

A foreign exchange (FX) rate is the value of the currency with respect to any other country's currency. When the rate of one country's currency is converted into another country's currency the value that comes out for trading or commercial use is called exchange rates.

And the Foreign exchange rates of any country are mainly determined by the demand and supply of currency of that country in the international markets, especially in the forex market where these currencies are used for international trade.

And the demand and supply of currency are influenced by various factors like the country’s economic condition, political instability, government monetary policy, inflation, the balance of payment, export-import policy and balance of payment etc.

For example, if the exchange rate between the Indian rupee and the US dollar is 80.71, it means that 80.71 Indian rupees is equivalent to1 US dollar.

And the foreign exchange rates between two or more countries do not always remain the same, it keeps changing and sometimes become highly volatile in the forex market. For example, if the currency value of any country is depreciating or becoming stronger against any country, it means exports will become expensive and imports will become cheaper.

Change in the currency price not only affects the export and import but also affects the sentiments of people using it in forex market trading. Let's find out what are the major factors influencing foreign exchange rates or currency prices.

Five Major Factors That Influence Foreign Exchange Rates

#1 Inflation

Rising Inflation is one of the biggest reasons behind the decrease in the value of the currency of any country. This is because the goods and services become costlier and the purchasing power becomes higher than the other currencies with which it is compared. While on the other hand, consistently lower inflation rates cause the currency value of the country to increase making it stronger in the international country market.

For example, if a product says in one country it costs one unit of money, while if inflation is high in any country it may cost 2 or more units of money for producing the same product. Due to inflation and purchasing power parity, different countries have different currency values. Hence, high-inflation countries have weaker currencies, while low-inflation countries have stronger currencies also affecting the foreign exchange market with price change.

2# Interest Rates

Inflation, interest rates and exchange rates are high with each other. And with the change in monetary policy by the government to control inflation or limit the liquidity of money in the market also affect the value of the currency in the international market.

Higher interest rates give lenders a higher return in an economy compared to other countries. When interest rates are high, foreign investors get attracted to invest for high returns also affects the exchange rates in the currency market. Central banks of a country use interest rates to check inflation which also affects the currency value.

3# Economic Condition

The economic condition of a country also plays a major role in currency value in the international market. A strong and positive economic condition attracts foreign investors for capital investment in the country also making the currency value stronger. While on the other hand, political turmoil, and poor economic growth discourage foreign investors that also depreciate the value of the currency either used for foreign trade or trading in the forex market.

4# Government Debts

The total national debt owned by the central bank of a country is a public debt that also influences the currency value of that country. A country with a huge amount of public debt is not good for the economic growth of the country.

The high national debt-laden country takes loans from foreign countries which leads to inflation. And few governments start printing more money to pay the part of debts that also leads to inflation. And foreign investors holding the sovereign bonds of such countries start selling these bonds in the open market, resulting in the exchange rate also decreasing.

5# Balance of Trade(Import-Export)

Terms of trade of a country mean the difference between the export and import of a country also highly influence the currency value of the country. Also called the balance of trade where if the export of a country exceeds the import, it means there is a higher demand for the country's exports. This will increase the revenue of the country from export which also increases the demand for the country's currency in the international market, improving its value in the forex market.

While on the other hand if the import of a country is greater than the export or consistently rising, then the forex reserve of the country also gets affected disturbing the currency value of the country making it cheaper in the forex market.

Five Other Factors Affecting Foreign Exchange Rate

Apart from the above five major factors, there are various aspects that influence the currency value in the foreign exchange market. These factors are not prime reasons but also influence the currency price of a country. As all these factors are also interrelated with the economic growth, government and money supply of the country. Let’s find out what are they.

#1 Economic Growth or Recession

When a country is going through a phase of recession, the interest in the country is likely to fall which leads to a decrease in the foreign capital inflow in the country. And when interest rates are high and low foreign capital inflow starts the value of currency also starts decreasing compare to other countries having better economic conditions.

#2 Current Account Deficits

Closely related to the balance of trade, if the current deficit of the country is rising means, the county is buying more compare to selling. The current account deficit consists of the total number of transactions including its exports, imports and debt. And the deficit in the current due to higher spending on imports also fluctuates as exchange rate of its currency.

#3 Political Instability

A stable unstable government of a country plays an important role in the value of the currency of that country. A stable government with a clear and strong economic policy also attracts foreign investment to the country. And when the investment in the country also lead by the increase he foreign capital it also increases its currency value. While a country with political unrest is likely to see a depreciation in the rate of its currency value.

#4 Government’s Intervention

Apart from above listed usual factors, the foreign exchange rates of a country are also controlled by the central government of a country. The central banks of the country on behalf of the government, use various tools and techniques to manipulate the currency.

Government adjust the interest rates accordingly, change the local leading rates, buy foreign currency or print more money to regulate the currency exchange rates. Though, the main motive of government intervention to use such techniques is to ensure the stability of its currency value and make the exchange rates favourable for the country.

#5 Speculation in Price Change

Finally, in the forex market, the price of the currency of any country is also influenced by the trading activities in the global markets. Forex traders make their positions in the trade with the speculation of a rise or fall in the price of currency between two countries.

Also Read: Currency Trading: What is Forex Trading & How Does it Work

In the forex market, when investors speculate the value of the currency will rise in the near future they buy the same in huge quantity. This speculative move leads to a rise in the value of currency resulting in the forex market price of currency also rising.

Similarly, when there is any negative news likely to come, like country election outcomes not favourable for the country, the traders start selling the currency of such country in the forex market. And when its value really decreases, they buy at lower prices and earn the profit made from forex trading. Such kind of activity also deprecates the value of the currency.

Also Read: Advantages and Disadvantages of Forex Trading: How to Start

Wrapping-up

The currency value of foreign exchange rates are determined as per the economy size, its strength, political dominance and demand in the international currency market. Mostly USD, British Pound, Euro and INR are traded in the currency market with huge volumes of trade. And as we discussed there are various factors that affect the price of the currency rates.

Inflation, interest rates, export-import, economic condition and government debts are prime reasons behind the fluctuation of currency in the forex market. However, apart from these fundamental factors, demand and supply in forex trading also affect the currency value when there is huge demand and supply of a currency against any other currency.

Also Read: Difference Between Fundamental Analysis and Technical Analysis

Traders in the forex market, take advantage of these currency rate fluctuations and earn unlimited money daily. If you are looking to earn from forex trading or want to earn profits from the currency market, you can also open a trading account and trade in INR or any other currency available for trading which can give you better returns compare to stock market.

Also Read: What is Profit Booking in Stock Market: Rules & Best Strategy

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Also Read:Trading Account: Types, How to Open and Documents Required

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Also Read: USD INR Options Trading Strategies Beginners Guide to Trade