5 Factors Affecting Currency Exchange Rate

Trends in currency exchange rate should be studied on a comparative basis. We can have different trends in foreign exchange values, if we compare currency “A” with that of Currency “B” and” C”. Following are the factors which influence the value of a currency over time.

1) Economic growth outlook - Typically, the more healthy and robust a country’s economy, the better its currency’s performance with its peers.

2) Inflation Trend- Generally, a currency will experience a drop in its value if there is a high level of inflation in the country or if inflation levels are forecasted to rise in future.

3) Government Policy - The currency exchange rate market usually reacts negatively to expanding government budget deficits, and positively to contracting budget deficits. 

4) Balance of trade – Unfavorable balance of trade tend to have a negative impact on a nation’s currency and vice versa

5) Political conditions - Generally, political instability will have a negative impact on a nation’s currency.

In short, any factor that affects the health of a nation’s economy positively will have a positive impact on the country’s currency and vice versa.
These factors should not be studied in isolation; one should do a comparative analysis with the other country in focus. For example, while analyzing the US Dollar with the Japanese Yen, one should study the above five factors with respect to the economies of US and Japan.

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