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Factors affecting the exchange rate

An exchange rate is the value of the currency of one country expressed in the currency of another country. An exchange rate or currency quotation is necessary to determine the proportions of currency volume in case of international trade in goods and services, cash flows, revaluation of accounts in foreign currency, etc. The cost basis of the currency is its purchasing power.

Prior to the abolition of the gold standard, purchasing power parity was determined by the content of gold in monetary unit. The exchange rate fluctuations were insignificant (+/- 1%) and they were associated with the transportation costs of gold abroad. After the abolition of the gold standard, the exchange rate was formed under the influence of supply and demand: in case of the increase of demand, the rate rose, and in case of the increase of supply, respectively, the rate decreased.

The formation of an exchange rate

The formation of an exchange rate is a complex process of interrelation of national and world economy and politics, therefore, in case of its forecasting various factors, which may have an impact on the currency quotes, are taken into account.

  • Inflation rate. The increase in the level of prices in the country leads to the decrease in purchasing power of its monetary unit, and, respectively, to the decrease in exchange rate.
  • Interest rates. Central banks of various countries have a significant impact on the rate of a national currency through the change in refinancing rate. When the interest rate hike is associated with the tightening of the monetary policy of the country, then the exchange rate rises, but if the rate rises because of high inflation, then the exchange rate will fall.
  • Balance of payments. The balance of payments of the country is the cash flow in the form of payments received and paid by the country. In case of the active balance of payments, the demand for national currency increases, thereby its rate strengthens as well. In case of the passive balance of payments, increases the demand for a foreign currency, thus the rate of a national currency decreases.
  • The competitiveness of goods of the country in the world markets. High competitiveness contributes to the increase of the country’s exports, and accordingly to the inflow of foreign currency and growth of the rate of its own monetary unit.
  • Speculative currency transactions and activity of financial organizations. If an exchange rate falls for some reason, then, in an attempt to eliminate currency risks, major financial organizations sell this currency, thus contributing even more to the weakening of its position in the Forex market.
  • Prices for energy and other raw materials. If the economy of a country is not diversified and depends mainly on the export of raw materials, then, in case the world commodity prices fall (oil, gas, gold, etc.), the national currency rate will fall as well.

In addition, exchange rates are affected by political situations in various countries, wars, cataclysms. More often, unexpected fundamental news leads to mass panic, and, consequently, to sharp exchange rate fluctuations, which eventually stabilize at new levels.

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