The currency exchange market is often said to be the largest investment market in the world. However, many people do not know how the process of determining the value of one currency in relation to another takes place. Essentially, currency exchange rates are set based on several basic factors that are consistently applied in all situations, as well as some factors that may vary, depending on the circumstances.
The fixed factors that impact currency exchange rates are generally identified as inflation, interest rates, and trade value. Trade value has to do with the ratio of business and service trading that takes place between the two countries that issue the currency. In the event that one country purchases more goods and services from a given country than it imports to that same country, the value of the each country will reflect that difference. In effect, the country that gains the most from the sale of goods and services between the two countries will have a currency that is rated higher in value.
Inflation and recession are economic factors that directly impact the ability of a country to purchase goods and services, both within the country and on the world market. High inflation will mean that the country will be less capable of purchasing goods and services. Decreased purchasing power will lead to the currency of that country being considered less desirable. Since the idea of exchanging currency is to maximize the worth of the investment in currency, inflation will directly lead to a depreciation of the worth of that nation’s currency in comparison to that of a country that is not currently experiencing inflation. Thus the currency exchange rate between the two countries shifts, until the period of inflation passes.
Directly related to inflation is the matter of interest rates. Also an important economic indicator, high interest rates mean less circulation of money through loans. Less money in circulation means less purchasing on the world market. This means that currency exchange rates for that country will also drop in value.
These three main factors in evaluating currency exchange rates, like other less relevant factors, can change in a matter of hours. That is one thing that makes investing in currency exchange such an exciting venture. The level of challenge with currency exchange rates can also be heightened when such issues as political turnovers and natural disasters also impact the economic nature of a country, and thus dictate a change in currency exchange rates for that nation’s currency.