What affects the value of a currency?

A variety of factors can affect exchange rate. With a good understanding of these factors you can use the forex markets as a good short term investment vehicle. The value of a currency is always relative to another currency so you can begin with a simple strategy of comparing two economies with each other. For example, when you buy Chinese Yuan, you are essentially buying a share of Chinese economy. The price of Chinese Yuan, like any company's stock price, reflects the market's expectation of current and future performance of the Chinese economy. Political and economical performance, inflation level, interest rate level, current account deficits, public debt, money supply as well as speculative activities and market psychology can all affect foreign exchange rate.

The foreign exchange rate is mainly determined by 7 factors, namely

1. Political and economical performance - Political stable countries with strong economic performance are very attractive to investors. Political turmoil, on the other hand, can cause the loss of confidence in a currency which leads to a devaluation.

2. Inflation level - In general, countries with consistently lower inflation rates see a rising currency value as their purchasing power increases relative to other currencies. When money in circulation exceeds the actual demand for the exchange of commodities in a country, inflation is the result.

3. Interest rate level - interest rate has significant short-term impact on the exchange rate. Difference in interest rates can cause capital, especially short-term capital flows from one country to another.

4. Current account deficits – Under a fixed exchange rate regime, a country's current account short-term surplus or deficit has little effect on the exchange rate. China is an example. Its huge current account surplus and foreign exchange reserve have no strong effect on Yuan's exchange rate.

5. In the floating exchange rate system, the current account status affects a country's exchange rate to a certain extent.

6. Public debt – Domestic growth is fuelled by local borrowings, hence a key factor in the value of a currency.

7. Money supply – Liquidity enables high flow of cash between people and is a sign of matured markets. Lack of money supply or liquidity curbs economic growth.

8. Speculative activities and market psychology – Like all aspects of our lives, financial markets are also affected by sentiments. Speculators ban on market sentiments to make their trades, an indication of this factors importance.

These factors will be explained in greater depth in advanced forex trading courses.

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