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1. Six key factors influence exchange rates between currencies: differentials in inflation rates, interest rates, current account deficits, public debt levels, terms of trade, and political stability and economic reforms.
2. A country with higher inflation or public debt levels will typically see depreciation of its currency, while lower inflation, interest rates, or debt levels are associated with a stronger currency.
3. Current account deficits indicate a country is importing more than it exports, creating excess demand for foreign currency and lowering the value of its own currency. Political instability or weak economic reforms can also weaken a currency.
1. Six key factors influence exchange rates between currencies: differentials in inflation rates, interest rates, current account deficits, public debt levels, terms of trade, and political stability and economic reforms.
2. A country with higher inflation or public debt levels will typically see depreciation of its currency, while lower inflation, interest rates, or debt levels are associated with a stronger currency.
3. Current account deficits indicate a country is importing more than it exports, creating excess demand for foreign currency and lowering the value of its own currency. Political instability or weak economic reforms can also weaken a currency.
1. Six key factors influence exchange rates between currencies: differentials in inflation rates, interest rates, current account deficits, public debt levels, terms of trade, and political stability and economic reforms.
2. A country with higher inflation or public debt levels will typically see depreciation of its currency, while lower inflation, interest rates, or debt levels are associated with a stronger currency.
3. Current account deficits indicate a country is importing more than it exports, creating excess demand for foreign currency and lowering the value of its own currency. Political instability or weak economic reforms can also weaken a currency.
Filed Under: Exchange Rate Regime, Forex Fundamentals, Inlation, !acroeconomics Aside rom actors such as interest rates and inlation, the exchange rate is one o the most im"ortant determinants o a country#s relati$e le$el o economic health% Exchange rates "lay a $ital role in a country#s le$el o trade, &hich is critical to most e$ery ree mar'et economy in the &orld% For this reason, exchange rates are among the most &atched, analy(ed and go$ernmentally mani"ulated economic measures% But exchange rates matter on a smaller scale as &ell) they im"act the real return o an in$estor#s "ortolio% *ere &e loo' at some o the ma+or orces ,ehind exchange rate mo$ements% -$er$ie& Beore &e loo' at these orces, &e should s'etch out ho& exchange rate mo$ements aect a nation#s trading relationshi"s &ith other nations% A higher currency ma'es a country#s ex"orts more ex"ensi$e and im"orts chea"er in oreign mar'ets. a lo&er currency ma'es a country#s ex"orts chea"er and its im"orts more ex"ensi$e in oreign mar'ets% A higher exchange rate can ,e ex"ected to lo&er the country#s ,alance o trade, &hile a lo&er exchange rate &ould increase it% /eterminants o Exchange Rates 0umerous actors determine exchange rates, and all are related to the trading relationshi" ,et&een t&o countries% Remem,er, exchange rates are relati$e, and are ex"ressed as a com"arison o the currencies o t&o countries% 1he ollo&ing are some o the "rinci"al determinants o the exchange rate ,et&een t&o countries% 0ote that these actors are in no "articular order. li'e many as"ects o economics, the relati$e im"ortance o these actors is su,+ect to much de,ate% 1% /ierentials in Inlation As a general rule, a country &ith a consistently lo&er inlation rate exhi,its a rising currency $alue, as its "urchasing "o&er increases relati$e to other currencies% /uring the last hal o the t&entieth century, the countries &ith lo& inlation included Ja"an, 2ermany and 3&it(erland, &hile the 4%3% and 5anada achie$ed lo& inlation only later% 1hose countries &ith higher inlation ty"ically see de"reciation in their currency in relation to the currencies o their trading "artners% 1his is also usually accom"anied ,y higher interest rates% 61o learn more, see 5ost78ush Inlation Versus /emand78ull Inlation%9 Get a Risk-Free $50K Practice Account with FOREX.com 2% /ierentials in Interest Rates Interest rates, inlation and exchange rates are all highly correlated% By
mani"ulating interest rates, central ,an's exert inluence o$er ,oth inlation and exchange rates, and changing interest rates im"act inlation and currency $alues% *igher interest rates oer lenders in an economy a higher return relati$e to other countries% 1hereore, higher interest rates attract oreign ca"ital and cause the exchange rate to rise% 1he im"act o higher interest rates is mitigated, ho&e$er, i inlation in the country is much higher than in others, or i additional actors ser$e to dri$e the currency do&n% 1he o""osite relationshi" exists or decreasing interest rates 7 that is, lo&er interest rates tend to decrease exchange rates% 6For urther reading, see :hat Is Fiscal 8olicy;9 3% 5urrent7Account /eicits 1he current account is the ,alance o trade ,et&een a country and its trading "artners, relecting all "ayments ,et&een countries or goods, ser$ices, interest and di$idends% Adeicit in the current account sho&s the country is s"ending more on oreign trade than it is earning, and that it is ,orro&ing ca"ital rom oreign sources to ma'e u" the deicit% In other &ords, the country re<uires more oreign currency than it recei$es through sales o ex"orts, and it su""lies more o its o&n currency than oreigners demand or its "roducts% 1he excess demand or oreign currency lo&ers the country#s exchange rate until domestic goods and ser$ices are chea" enough or oreigners, and oreign assets are too ex"ensi$e to generate sales or domestic interests% 6For more, see 4nderstanding 1he 5urrent Account In 1he Balance - 8ayments%9 =% 8u,lic /e,t 5ountries &ill engage in large7scale deicit inancing to "ay or "u,lic sector "ro+ects and go$ernmental unding% :hile such acti$ity stimulates the domestic economy, nations &ith large "u,lic deicits and de,ts are less attracti$e to oreign in$estors% 1he reason; A large de,t encourages inlation, and i inlation is high, the de,t &ill ,e ser$iced and ultimately "aid o &ith chea"er real dollars in the uture% In the &orst case scenario, a go$ernment may "rint money to "ay "art o a large de,t, ,ut increasing the money su""ly ine$ita,ly causes inlation% !oreo$er, i a go$ernment is not a,le to ser$ice its deicit through domestic means 6selling domestic ,onds, increasing the money su""ly9, then it must increase the su""ly o securities or sale to oreigners, there,y lo&ering their "rices% Finally, a large de,t may "ro$e &orrisome to oreigners i they ,elie$e the country ris's deaulting on its o,ligations% Foreigners &ill ,e less &illing to o&n securities denominated in that currency i the ris' o deault is great% For this reason, the country#s de,t rating 6as determined ,y !oody#s or 3tandard > 8oor#s, or exam"le9 is a crucial determinant o its exchange rate% ?% 1erms o 1rade A ratio com"aring ex"ort "rices to im"ort "rices, the terms o trade is related to current accounts and the ,alance o "ayments% I the "rice o a country#s ex"orts rises ,y a greater rate than that o its im"orts, its terms o trade ha$e a$ora,ly im"ro$ed% Increasing terms o trade sho&s greater demand or the country#s ex"orts% 1his, in turn, results in rising re$enues rom ex"orts, &hich "ro$ides increased demand or the country#s currency 6and an increase in the currency#s $alue9% I the "rice o ex"orts rises ,y a smaller rate than that o its im"orts, the currency#s $alue &ill decrease in relation to its trading "artners% @% 8olitical 3ta,ility and Economic 8erormance Foreign in$estors ine$ita,ly see' out sta,le countries &ith strong economic "erormance in &hich to in$est their ca"ital% A country &ith such "ositi$e attri,utes &ill dra& in$estment unds a&ay rom other countries "ercei$ed to ha$e more "olitical and economic ris'% 8olitical turmoil, or exam"le, can cause a loss o conidence in a currency and a mo$ement o ca"ital to the currencies o more sta,le countries% 5onclusion 1he exchange rate o the currency in &hich a "ortolio holds the ,ul' o its in$estments determines that "ortolio#s real return% A declining exchange rate o,$iously decreases the "urchasing "o&er o income and ca"ital gains deri$ed rom any returns% !oreo$er, the exchange rate inluences other income actors such as interest rates, inlation and e$en ca"ital gains rom domestic securities% :hile exchange rates are determined ,y numerous com"lex actors that oten lea$e e$en the most ex"erienced economists lummoxed, in$estors should still ha$e some understanding o ho& currency $alues and exchange rates "lay an im"ortant role in the rate o return on their in$estments%