Foreign currency market is largely demand and supply driven. So if the demand for one currency goes up, its value appreciates or if a currency is in abundant supply, its value will decline. A currency’s strength is mainly determined and driven by the strength of the economy of the country that it represents. For example, the US Dollar’s value is mainly dependant on the strength of the US economy and any major changes in it will lead to changes in the foreign currency market too. However, it does not mean that even a small change in the fundamentals of an economy will result in a change in the value of its foreign currency.
Let’s try to identify the various factors that impact foreign currency movements and to what extent.
Changes In The Interest Rate Policy Of A Country
Interest rate policy of any country is a key driver of its currency exchange rate. If a country raises its interest rates, it is likely to attract more foreign investors, thus resulting in the strengthening of its currency. For example, if the interest rates in the Euro zone increase, the investors in the US and other countries may sell their local holdings and instead invest in euro bonds. This will lead to an increase in the value of the euro and a decline in the value of the US Dollar and the currencies of other countries.
Changes In The Gold Prices
An increase or decrease in the prices of gold has an instant impact on the currencies of countries which are the major producers and exporters of gold. Say if the prices of gold goes up, the currencies of Australia and Canada who are the leading exporters and producers of gold will strengthen. Similarly, the currencies of gold importing countries will weaken if gold prices rise.
Now some countries use gold as a standard for monetary exchange. This means that a unit of a country’s currency can be exchanged for a specific weight of gold. Investors can analyze the change in gold prices and than decide to exchange currencies to take advantage of the price change to maximize their profits.
Changes In The Prices Of Crude Oil
Currencies of oil dependant nations like the US, Japan and India are highly dependant on the price of the crude oil. Say if the price of crude oil increases, the imports of these nations will surge, leading to increased outflows and thus have a negative impact on the value of their currency.
Political Conditions Of A Country
The stability or instability of the government in a country can also lead to changes in the value of a currency. A stable government is an indicator of consistency in economic policies and continued movement towards growth. In comparison, an unstable government indicates uncertainty related to economic policies and thus may have a negative impact on the country’s currency value.
Central Bank Or Government Intervention
Sometimes, a country’s central bank also participates in the forex market in a bid to stabilize prices. A central bank may flood the forex market with their country’s currency in a bid to lower its price. Or, they may buy a significant amount of their own currency and thus try to boost its price.
Many a times, it is not these factors but merely speculation about these factors that leads to changes in the value of the currency of a particular country. Although foreign currency markets move in response to changes in any of the above factors, the impact is short term. The enormous size and the massive volumes witnessed in the foreign exchange market restrict the impact of any change in any of the above factors.