6 Factors That affects Exchange Rates

 Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are included the most watched, analyzed and govern mentally manipulated economic measures.
6 Factors That affects Exchange Rates
1.Differentials in inflation 
2.Differentials in Interest Rates
3.Current-Account Deficits
4.Terms of trade
5.Public dept
6.Political Stability and Economic Performance

 

 1.Differentials in inflation 

  As a common rule, a country with a consistently lower inflation rate exhibits that which goes up currency value, as its purchasing power increases relation to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, and also U.S.and Canada achieved low inflation just later.
 2.Differentials in interest
Interest rates, inflation and exchange rates are  highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values.Higher interest rates offer lenders in an economy a higher return relative to other countries. Thus, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, though, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency decreases.The opposite relation exists for decreasing interest rates - that is, lower interest rates tend to low exchange rates.(For more reading, see What Is Fiscal Policy?)
Current-Account Deficits
 The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. (For more, see Understanding The Current Account In The Balance Of Payments.)
5.Terms of  trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners.

4. Public DebtCountries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.

In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate. 6. Political Stability and Economic PerformanceForeign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.