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Factors The determinants of exchange rates are numerous and can be divided into economic factors, political (monetary policies, other policies that may affect the economic situation of the country) and market sociology (rumors, risk perception by investors, etc. ). In this article we will see what are the most important factors that affect exchange rates.

Inflation

Countries who regularly have higher inflation levels (in other words, there is a constant loss on the acquisition power or a persistent price increase), are more vulnerable to see impacts in their exchange rate than others with lower inflation levels. This means that the higher the inflation levels tend to make local currency weaken compared to other currencies. An economy with inflationary trends is constantly pressured by a generalized increase in prices.

For instance

If in a country it is estimated 5.0% inflation during the year, and its neighbor country has 2.0%, it is understood that the country with higher inflation would have depreciation in its currency exchange in regards to the other one.

Interest rates

Being the interest rate a decision of central banks, a raise or low interest rates may be a factor to draw foreign capital through the acquisition of local currency.

In other words, if the central bank chooses to increase rates, the impact caused is a high demand for debt securities of the country and therefore when foreigners invest in a country with rates on the rise they will generate a high demand for the currency of such nation.

For instance

When having an increase of 40 base points (0.4%) on the rate of US bonds, it would mean a higher demand of such bonds (in this case to acquire them, the investor should change his local currency to dollars).

Capital Flows

Depreciation in the exchange rate of a country implies that imports will be more expensive and this will reduce the interest in acquiring foreign goods. On the other hand, exporting nations may benefit from these movements, becoming more attractive to purchase its products. Excessive demand for a currency which is not local, results in the increase of the exchange rate, in other words, the local currency lose acquisition value compared to the currency with most demand.

For instance

Pressures due to a high exchange rate, meaning that a dollar which gains more ground compared to a peso, implies an impact over more expensive imports and a greater momentum for exports to USA, in order to take advantage of an exchange rate that offers an exporter more pesos per each dollar that he receives. A deficit in the current account affects the exchange rate since goods must be acquired with a more expensive currency. Considering the deficit we may infer that excessive demand of the dollar in order to cover more imports instead of exports makes the dollar better valued than the peso.

International Businesses

Countries who have more diplomatic and trade agreements usually promote trade based on many exports, a condition agreed through treaties. Greater efforts with the purpose of promoting trade with neighbor countries tend to increase exports. It is important to mention that exports should be higher than imports, in order to benefit the exchange rate that impacts the value of local currency.

For instance

Signing a trade agreement between two nations in order to promote trade between these ones might benefit the exchange rate of the country that makes more exports, since the exporting country would receive the highest amount of foreign currency from its counterpart.

Financial Stability

In most cases, investors tend to choose countries with a healthy economic performance. Thus, countries with economic indicators that show difficulties tend to see less flow of foreign capital into their country and therefore the demand of its local currency is not as great as in countries that show better figures.

For instance

After linking several consecutive quarterly periods with economic data which exceeded expectations, the economy of a certain country observes a 4.5 percent of increase in demand for debt securities of such nation.

This increase causes its currency to be valued, since while there is a high demand for such instruments, the local currency would benefit.