During my usual roaming around the web I came across an entry from Oanda titled Top 5 Factors Affecting Exchange Rates. Those five factors are:
1. Interest Rates
2. Employment Outlook
3. Economic Growth Expectations
4. Trade Balance
5. Central Bank Actions
I think whoever authored this item actually made things a lot more complicated than need be and has things here are a couple of different levels in the discussion. There are only two things which impact the exchange rate of a currency – items which speak directly to the supply/demand equation. One is capital flow. The other is trade flow. Everything else speaks to one or both of those primary movers.
A swirl of overlapping influences
Let’s take the first entry above, interest rates, as an example. What impact does the level of interest rates, or the change in that level, have on a currency’s exchange rates? The most direct impact is on the capital flow side in terms of making a currency more or less attractive to investors (either for investing or for borrowing, as we’ve seen from the carry trade). Interest rates also factor into the trade flow side in as much as they have an impact on the domestic economy and the ability of domestic consumers to purchase and/or produce trade goods.
The second item on the list is Employment Outlook, which to my mind either feeds up into or spins off out of #3, Economic Growth Expectations. That then speaks to the trade flow side of equation (#4) and prospectively to interest rates as well. As noted above, that latter element feeds through into the capital flow side of the equation.
And keep in mind that where exchange rates are concerned everything must be taken in comparison to something else. You cannot look at one economy in a vacuum because the exchange rates are determined by looking at two matched against each other.
The one “external” force in all this is government or central bank intervention. Some are quite active in attempting to influence exchange rates directly. For example, at this writing Brazil is buying dollars twice a day to keep the real from appreciating. Not all countries do this, though, and most of the time it’s only done in perceived extreme circumstances to keep the markets getting out of order.
Another kind of intervention is government regulation and fiscal policy. These things, however, flow through into the capital flow and trade flow considerations. They do not directly act on exchange rates.
Now, some will say that inflation directly impacts the value of a currency. In purchasing power terms that is most definitely true. Inflation only has an indirect impact on exchange rates, however, as a contributing factor in the determination of capital and trade attractiveness. After all, if every economy is experiencing 10% inflation, there is no relative impact for exchange rates.