In: Economics
Explain how foreign exchange rates, economic conditions, and the international business environment affect prices charged in foreign markets.
Foreign Exchange rate (ForEx rate) is one of the most important means through which a country’s relative level of economic health is determined. A country's foreign exchange rate provides a window to its economic stability, which is why it is constantly watched and analyzed. If you are thinking of sending or receiving money from overseas, you need to keep a keen eye on the currency exchange rates.
The exchange rate is defined as "the rate at which one country's currency may be converted into another." It may fluctuate daily with the changing market forces of supply and demand of currencies from one country to another. For these reasons; when sending or receiving money internationally, it is important to understand what determines exchange rates.
1. Inflation Rates
Changes in market inflation cause changes in currency exchange
rates. A country with a lower inflation rate than another's will
see an appreciation in the value of its currency. The prices of
goods and services increase at a slower rate where the inflation is
low. A country with a consistently lower inflation rate exhibits a
rising currency value while a country with higher inflation
typically sees depreciation in its currency and is usually
accompanied by higher interest rates
2. Interest Rates
Changes in interest rate affect currency value and dollar
exchange rate. Forex rates, interest rates, and inflation are all
correlated. Increases in interest rates cause a country's currency
to appreciate because higher interest rates provide higher rates to
lenders, thereby attracting more foreign capital, which causes a
rise in exchange rates
3. Country’s Current Account / Balance of Payments
A country’s current account reflects balance of trade and
earnings on foreign investment. It consists of total number of
transactions including its exports, imports, debt, etc. A deficit
in current account due to spending more of its currency on
importing products than it is earning through sale of exports
causes depreciation. Balance of payments fluctuates exchange rate
of its domestic currency.
4. Government Debt
Government debt is public debt or national debt owned by the
central government. A country with government debt is less likely
to acquire foreign capital, leading to inflation. Foreign investors
will sell their bonds in the open market if the market predicts
government debt within a certain country. As a result, a decrease
in the value of its exchange rate will follow.
5. Terms of Trade
Related to current accounts and balance of payments, the terms
of trade is the ratio of export prices to import prices. A
country's terms of trade improves if its exports prices rise at a
greater rate than its imports prices. This results in higher
revenue, which causes a higher demand for the country's currency
and an increase in its currency's value. This results in an
appreciation of exchange rate.
6. Political Stability & Performance
A country's political state and economic performance can affect
its currency strength. A country with less risk for political
turmoil is more attractive to foreign investors, as a result,
drawing investment away from other countries with more political
and economic stability. Increase in foreign capital, in turn, leads
to an appreciation in the value of its domestic currency. A country
with sound financial and trade policy does not give any room for
uncertainty in value of its currency. But, a country prone to
political confusions may see a depreciation in exchange
rates.
7. Recession
When a country experiences a recession, its interest rates are
likely to fall, decreasing its chances to acquire foreign capital.
As a result, its currency weakens in comparison to that of other
countries, therefore lowering the exchange rate.
8. Speculation
If a country's currency value is expected to rise, investors
will demand more of that currency in order to make a profit in the
near future. As a result, the value of the currency will rise due
to the increase in demand. With this increase in currency value
comes a rise in the exchange rate as well.