Factors Determining Exchange Rates
Before you try your hand at currency trading, it is important to understand the main drivers behind currency exchange rates. Some factors are psychological (like the behavior of the market) and others are cyclical (driven by the economic trends). These factors include inflation, interest rates, balance of payments, public debt and political stability.
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Inflation
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Inflation allows a currency trader to compare the relative strength of a currency against another. A lower inflation rate signifies that prices of goods and services are increasing at a slow pace. These goods and services then become cheaper for those countries importing goods from that country into theirs. Generally, this will create an imbalance which will cause currency in the receiving country to appreciate in value.
Interest Rates
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Interest rates are looked at as the cost of money. That is, savvy investors usually want to invest their money wherever they can get paid a higher price. Returns tend to be higher in those countries with higher interest rates. When a divergence occurs between countries with low default risk, investments will flow to that nation state which will increase the demand for the currency and cause the currency to appreciate.
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Trade Balance
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When a country runs an account deficit it is referred to as an imbalance of payments. This is generally caused when a country imports more than it exports which tends to create disparities in the exchange rate for the country that has the trade surplus. In time, the exchange rate will usually adjust downward, making products more affordable for foreigners.
Public (Government) Debt
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Government debt is created by borrowing across nations. The rate of borrowing is generally driven by a country's monetary policy (interest rates). In general, a government will use debt to finance deficit spending which leads to an increase in inflation and currency devaluation.
Political and Economic Factors
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Most investors do not like risk, and therefore prefer to invest their money in stable economies. They tend to avoid investing in countries with political turmoil and economic stagnation. A nation whose government and economy are stable will attract more buyers (and vice versa) which creates more demand for that nation's currency.
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