The regular movement of the forex rate affects everyone regardless of whether you are travelling to a foreign country or buying an item online.
Every commodity is affected by the economic law of supply and demand and the forex rate is not any different. The demand and supply of a country’s currency is reflected in its foreign exchange rate.
During dips in the economy, consumers do not spend as much as they would during an economic upswing and this affects international trade.
This causes a country’s currency to decline compared to countries that are not in the throes of an economic downslide.
If a country experiences a boost in its economy, the value of its currency will receive a similar boost, unless its government decides to take action.
Also read: The 3 Determinants of Foreign Exchange Rates
1. Growth of the Economy
A country’s economy must expand in order for it to meet the growing needs of an increasing population. The problem that arises is if the growth is too rapid.
This causes an increase in commodity prices to overtake increases in salaries. This, in turn, causes consumers to decrease their spending even in cases where workers have received wage increases.
Most countries set an annual growth in its economy at a targeted 2%. In cases where the growth percentage is higher than this target, the inflation rate will increase.
In this instance, the central bank of the country will take steps to increase the interest rates. Increasing the interest rate causes an increase in the borrowing cost.
This causes consumers to decrease their borrowing which slows down general spending trends. Traders can use this to their advantage as a change in the interest rates is indicative of a change in the foreign currency rate.
During times of deflation the opposite is true and it is normally a sign that the country’s economy is in the process of stagnation.
National banks tend to lower interest rates during these times in order to increase consumer spending. The banks undertake this process to try and reverse deflation.
2. Interest Rates
The interest rates that the central bank sets affect interest rates that are charged to borrowing clients by their respective financial institutions.
When a country’s economy is under-performing, the central banks will consider a lowering of interest rates to boost borrowing.
The lower interest rates often cause consumers to borrow more and increase their spending which aids in a boost of the economy.
If the economy becomes too active, the national bank may increase the benchmark rate which will cause an increase in the rate for borrowings. This makes borrowing expensive which will slow down consumer spending.
This fluctuation is relevant to investors looking to gain solid returns on their funds. Asset yields in a currency are normally increased with an increase in interest rate.
This causes a demand by investors for that currency and ultimately causes an increase in the currency’s value. In times when interest rates decline, investors shy away from the currency as they will not be getting a satisfactory yield.
Also read: 5 Advantages of A Managed Forex Account
The effect these factors have on currency rates is important for forex brokers. Traders should keep an eye on interest rates and the economic climate of the currency pairs they are trading.