Dec 19, 2016

If you follow the news daily, or even occasionally, you would have surely heard about the foreign exchange rate. They’re every day’s hot discussion topic. And while financial experts might argue about the finer details of a country’s exchange rate, everyone agrees on one important point.

Foreign exchange rates matter. They matter for us, personally. They matter for a country’s economy as a whole. On a micro level, foreign exchange rates affect all of us who travel to other countries as it impacts our buying power. And, although many of us might not be aware of it, they impact us within the country as well as the prices of commodities and the fluctuations in foreign exchange rates are interlinked. On a macro level, exchange rates are even more crucial as they directly affect the country’s import-export ratio and depend on the country’s sociopolitical situation.

But what exactly is an exchange rate? Let’s get that out of the way before we move on to address how it is set. To put it simply, an exchange rate is the price of a currency when compared with that of another currency. An important thing to remember here is that the price of a currency cannot be determined alone. It’s relative. It is always measured with respect to another currency. So the dollar’s exchange rate would be measured against the pound or the yen.

What determines an exchange rate?

The thing to know about exchange rates is that they’re free-floating. This means that the market forces determine the exchange rate rather than the state. But what are some of the factors involved in it, you might ask. Don’t worry. Here are some of the most important ones:

1. Inflation

Inflation can be simply described as a continuous increase in the price of goods and services in the country. The products we buy now were cheaper when our parents bought them. What went wrong then? Nothing in particular. It’s inflation and it happens all the time. What’s important for the exchange rate is the rate of inflation. The country with lower inflation rate will generally have higher exchange rate because the price of the currency of a country depends upon the purchasing power of its citizens.

2. Interest rates

Interest generally serves as the profit on an investment. If you’re investing in Singapore, the higher its interest rates, the more your profit would be. And the country with high interest rates attracts more foreign investment and capital driving up its exchange rates.

3. Debt                                 

The general perception about the public debt is that debt is bad. While that might not always be true, large public debts do drive investors away because the inflation rates are higher. And we already know what happens to the exchange rate when inflation rates go up.

4. Sociopolitical conditions

When the UK received a shock after the results of the Brexit election, the pound’s exchange rates took a nosedive. The same thing happened with the dollar after Trump was elected. Why is that the case? Instability is always bad for investment. This is why investors seek out countries with stable sociopolitical conditions. This is why political turmoil in countries like Venezuela has sent their currency’s price spiraling downward. A stable country’s currency generally has a relatively higher exchange rate.

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