A nation's currency exchange rate is one of the most important determinants of its economic health. Along with 澳洲幸运5官方开奖结果体彩网:interest rates and inflation rates, ex🌺change rates play a vital role in a nation's level of trade, which is critical to nearly every free market economy in the world.

For this reason, exchange rates are among the most watched and analyzed economic numbers. However, exchange rates matter on a smaller scale as well: they impact the 澳洲幸运5官方开奖结果体彩网:real return of an inve꧑stor's portfolio. Let's look at five important factors that influence exchange rates.

Overview of Exchange Rates

Currency rates constantly fluctuate, making them worth more or less compared with other currencies. A rise in the value of its currency makes a nation's imports less expensive for its citizens to buy and its exports more expensive for consumers in foreign markets. A decrease in the value of its currency mak🌃es its imports more expensive and its exports less expensive in foreign markets.

A higher exchange rate can be expected to damage a country's 澳洲幸运5官方开奖结果体彩网:balance of trade. That is, the country is making less on its exports and spending more on its imports💞. A lower exchange rate can be expected to improve the balaไnce of trade.

Factors that Influence Exchange Rates

The ups and downs of a nation's exchange rate reflect many factors. Each of these factors is related to the trading relationship between the nation and its major trading partners. Exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants, in no particular order. The relative importance of these factors is subject to debate.

1. Differences in Inflation

A country with a relatively 澳洲幸运5官方开奖结果体彩网:low inflation rate usually experiences a higher currency value, as its purchasing power increases relative to other currencies. During the last half of the 20th century, the countries with low inflation included Japan, Germany, and Switzerland, while the U.S. and Canada achieved low inflation only later.

Countries experiencing higher inflation typiꦚcally see depreciation in their currency versus the currencies of their trading partners. This is also usually accompanied by higher interest rates.

2. Differentials in Interest Rates

Interest rates, inflation, and exchange rates 澳洲幸运5官方开奖结果体彩网:are all highly correlated. By changing interest rates, 澳洲幸运5官方开奖结果体彩网:central banks exert influence over both inflation and exchangeꩲ rates, and interest rate changes ♔affect inflation and currency values.

Higher interest rates offer banks and other lenders a better return than in other countries. Higher interest rates attract 澳洲幸运5官方开奖结果体彩网:foreign capital and cause the exchange rate to rise.

The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors drive the currency down. The opposite relationship exists for decreasing interest rates. That is, lower interest rates tend to decrease exchange rates.

3. Current Account Deficits

The current account is the balance of trade between a country and its trading partners, reflecting all payments between coun🐈tries for goods, services, interest, and dividends.

A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives throuꦆgh sales of exports, and it supplies more of its own currency than foreigners demand for its products.

The 澳洲幸运5官方开奖结果体彩网:excess demand for foreign currency lowers the cou♑ntry's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generaౠte sales for domestic interests.

4. Public Debt

Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with 澳洲幸运5官方开奖结果体彩网:large public deficitsꦰ and debts are less attractive to foreign investors.

The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.

In the worst-case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds or increasing the money supply), then ꦇit must increase the supply of securities for sale to foreigners, thereby lowering their prices.

Finally, a large debt may prove worrisome to foreign investors if they believe the country is at risk of 澳洲幸运5官方开奖结果体彩网:defaulting on its obligations. Foreigners will be lesꦬs willing to o♚wn securities denominated in that currency.

For this reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate.

5. Terms of Trade

A ratio comparing 澳洲幸运5官方开奖结果体彩网:export prices to import prices, the 澳洲幸运5官方开奖结果体彩网:terms of trade is related to current accounts and the 澳洲幸运5官方开奖结果体彩网:balance of payments.

If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value).

If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease with those of its trading partners.

How Currency Rates Influence Investments

Foreign investors and foreign companies seek out stable countries with strong economies in which to invest their capital. A country ౠwith such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk.

Political turmoil, in particular, can cause a loss of confidence in a currency and a movement of capital to more stable countries.

The Bottom Line

Changes in exchange rates can have a real impact on investors' portfolios. The exchange rate of the currency in which a portfolio holds the bulk of its investments determines that portfolio's real return. A declining exchange rate decreases the purchasing power of income and capital gains derived from any returns.

Moreover, the exchange rate influences other income factors such as interest rates, inflation, and even capital gains from domestic securities. While exchange rates are determined by complex factors that can leave even economists flummoxed, investors should still keeꦉp an eye on exchange rates, as they play an important role in the rate of return on their money.