Why does the exchange rate change? - September 23, 2018
Exchange rates fluctuate all the time as they are a natural part of the economy. Still, sometimes it might be hard to understand why prices move around. We collected the most common reasons behind these changes to help you understand the markets better.
Some currencies seem to be on the rise constantly while others have long and bad periods. What are the most common factors that influence exchange rates?
Supply and demand
The most obvious reason behind price movements is the change in supply and demand. The bigger the demand for something, the higher its price will be. It works the other way around too: if supply is too high, the price will become lower. This isn’t only true for currencies, it’s a basic truth of economy. What’s more, all the reasons below are connected to the truth of supply and demand in some ways.
We often write about interest rates and how they change for a good reason: they are very important. The higher the interest rate is, the better return a currency can have. This usually leads to higher demand, therefore value in currencies. But interest rate isn’t this simple: stronger economies usually have lower interest rates but strong currencies. This is why the USA, the EU, the UK, and many other countries have low interest rates but valuable money.
Inflation is the devaluation of a currency. It’s measured through the price levels of goods and services. If goods become more and more expensive over a period of time, we talk about inflation. (The opposite of that is deflation.) If inflation is high, the value of a currency usually falls, because it means that the economy behind the currency is weaker.
Generally speaking, the stronger a country’s economy is, the stronger its currency is. The main factor in this is usually the productivity and efficiency of the economy. If a country performs well, its currency will do well too. Government debt can also influence exchange rates: the higher the debt, the less attractive the currency is. But this is not always true. The US has rather high debt, but its currency remains valued high, since the country has a strong economy.
Political intervention can change the value of currencies, too. If a currency needs to be stabilized, central banks usually start to buy their own currency from the market. This leads to higher demand which – as we discussed it before – means higher value. This technique doesn’t always help, though. When Turkish lira crashed this year, politicians did everything they could to stop the freefall, but so far nothing helped.
Speculation is somewhat like political might. Investors with enough wealth can influence the prices of a currency. If they think that a country is in bad shape they can start to sell its currency. If they sell enough of the currency, markets will follow, and prices will indeed fall. After weakening the currency enough, they can buy their money back at lower prices and can wait for the rates to go back up.
These are the most common factors that influence exchange rates. Not all of them are at work all the time and not all of them are true for all currencies. Still, supply and demand remain a golden rule for price changes on the markets.
Disclaimer: This analysis is for general information and is not a recommendation to sell or buy any instrument. Since every investment holds some risk, our main business policy is based on diversification to minimize threats and maximize profits. Innovative Securities’ Profit Max has a diversified portfolio, which contains liquid instruments. This way, our clients can maintain liquidity, while achieving their personal investment goals on the long term.