Do you ever hear people say the EURO or the Australian dollar has fallen, but never knew why? This article will explore some of the critical factors that impact the value of a currency: Inflation, Interest rates, government debt, political stability, and speculation.
- Inflation rates
Inflation is the rise in prices of a country’s goods and services. Each country will have different inflation rates. When inflation rises, each unit of currency will buy fewer goods and services than before. A country with a lower inflation rate will be more attractive to foreign investors as goods and services are cheaper. In turn, an increased demand for low inflation rate currencies will increase its value.
The general rule of inflation
- When the inflation rate increases the value of the currency decreases
- When inflation rate decreases/rises slowly than the value of the currency increases
2. Interest rates
Interest rates is the amount of money a lender will charge someone for borrowing their money. When interest rates increase, more foreign investors want to deposit money in that currency. Primarily, due to higher interest rates providing a higher return for lenders. In turn, the demand for that currency appreciates.
The general rule of Interest rates
- When interest rates increase the currency increases
- When interest rates decrease then the currency decreases
3. Government debt
Governments with large national debt, will appear risky and thus find it challenging to attract foreign investment. If there is any suspicion that a government will default on its national debt, then investors will sell their government bonds. Ultimately causing a decrease in the demand for currency and its value.
The general rule for government debt
- Low government debt increases currency value
- Large government debt decreases currency value
4. Political performance
A country’s political situation can affect the future value of their currency. Political stability provides certainty for investors. If a country is politically unstable, then the economic growth for that country is jeopardized. Primarily, because consumers will not invest in a country that is risky/uncertain, and if consumers do not invest then an economy will not grow. Therefore, politically stable countries are more attractive to foreign investors, causing an increase in foreign capital into that country and an appreciation of that currency.
The general rule of political stability
- Politically stable increases currency value
- Political instability decreases currency value
Speculation is the prediction of an event without firm evidence. Speculations about the potential rise/fall in currencies strongly influences its value.
If a country’s currency is speculated to rise, investors will demand more of the currency to make a profit in the future. An increase in the demand for a currency increases its value. Newspapers and articles may speculate an rise in a currency due to increases in interest rates, political stability, a slowdown of the inflation rate or even governments paying off their debt.
However, if a country’s currency is expected to fall, investors will look to sell the currency and repurchase it a lower price or sell it altogether. Ultimately, a decrease in the demand for a currency decreases its value. Speculators may predict a decline in a currency value due to political unrest, an increase in government debt, a decrease in interest rates, or even a transition into a recession.
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The information above should not be taken as financial advice. Youth Investment Group has no liability for personal financial interests or investment decisions. You should make your own investment decisions based upon your own research and what you believe is best for you.
Writen by Patrick McLoughlin, Associate of YIG