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Factors influencing currency rates (Yield Differential (A country's…
Factors influencing currency rates
Yield Differential
A country's interest rate will affect the demand for and supply of its currency by influencing its capital flows
The difference between interest rates in various countries and how it affects currency values
Higher domestic interest rates contrasted to other countries' interest rates will tend to make the domestic currency more attractive to overseas investors, causing the value of the domestic currency to increase, all other things being equal
Lowering domestic interest rates will tend to make the currency less attractive
As an example, the yield on British government securities (gilts) is increased relative to that of Japanese government securities. This should not only increase the inflow into GBP but should also reduce the outflow of GBP into Japanese securities. The increased inflow into British securities should increase the value of the pound and reduce the value of the Japanese yen
Government budget surplus or deficit
If a government has a large budget surplus, the market will vernally react positively causing a currency's value to rise
If there is a large budget deficit is is often because the government has miscalculated its figures, thus failing to inspire market confidence and causing a currency to go down in value
Balance of payments
Surpluses and deficits in the export-import trade of country's goods and services are indicative of that country's competitiveness
If a country has a balance of payments surplus, the value of its exported goods and services exceeds the value of those imported. This will have a positive effect on a country's exchange rate relative to other currencies
If the value of a country's imports is greater than the value of the goods it exports, it will have a balance of payments deficit. This will have a negative effect on its currency
Economic conditions
Determine the likely direction of a country's exchange rate
The brighter the economic outlook for a country, the stronger its currency will tend to be
Economic factors such as unemployment levels, retail sales, GDP and industrial output will also affect currency rates
Economic growth will stimulate demand for a currency both through capital flows into the country because of attractive investment opportunities and through current account flows because of increased supply of and demand of the country's traded goods and services
A credit boom may cause demand for overseas good and services, and may cause a currency to weaken
Political considerations
Events inside the country in question will influence how the currency moves
Government policies may have considerable impact on a country's economic performance and therefore the value of its currency
Where an economy is overheating, a government may increase taxes to reduce spending
Historically, in times of political instability, the Swiss franc and Japanese Yen have been refuge currencies, causing the value of these currencies to rise relative to other currencies. An unstable or corrupt political regime will have a negative effect on a country’s currency, as would the outbreak of civil war.
Inflation rates
Higher rates of inflation reduce a country's competitiveness in international markets
Consumers will try to avoid the effects of inflation. Where one country has a high inflation rate in contrast to another country's rate, this will reduce the purchasing power of the country with the higher level of inflation. This will cause the value of its currency to fall
Consumers tend to buy goods and services from countries with lower inflation rates as they appear more attractive. Therefore the demand for the currencies of countries with the lower inflation rates will increase causing their values to increase
Natural resources
The discovery or existence of valuable natural resources such as oil or gas can cause a currency to strengthen
Non political events
Natural disasters such as earthquakes or tsunamis can negatively effect a currency either by reducing demand for a currency (eg a decline in tourism) or because the country's financial system is unable to function
Government controls
The introduction of exchange controls may prevent the panic outflow of capital. An alternative may be to devalue a country's currency which could reduce confidence in the currency and have a negative effect on exchange rates
Central bank intervention
Occasionally a central bank may intervene in the markets by buying its own currency in an attempt to support demand or defend exchange rates. This can only ever be a short term measure