Taken as a whole, the economic forces governing the exchange rate are
enormously complex. However, there are a handful of relatively simple
factors that have a clear and predictable impact on the rate. Inflation
is the first of these factors, and is one of the most important.
According to Investopedia,
during a period economic or price inflation, the domestic value of a
country's currency decreases, meaning people need more money to pay for
basic goods and services. One of the best examples of inflation occurred
in Germany during the early 1920s, when prices rose so sharply in
response to the government's feverish printing of paper money that an
entire wheel barrel filled with German Marks was insufficient to
purchase a single newspaper.
At one point, one U.S. Dollar was worth approximately one trillion German marks. While this is an extreme example of hyperinflation, it demonstrates the point well when prices rise, the real value of money drops, decreasing spenders' purchasing power and weakening the economy. In response to this drop in domestic value, a country's currency loses worth in the international market, lowering its exchange rate. For more information on inflation in the United States, investors can learn about the Consumer Price Index (CPI) and other important factors at the Bureau of Labor Statistics.
Another major factor behind the exchange rate is interest rates. Often determined by a country's central bank or federal government, interest rates control and affect many important financial products, including mortgages, loans, credit cards and certain investments. Because higher interest rates give lenders within a country better returns relative to those in another country, they tend to attract capital from foreign investors, increasing the value of the country's currency and causing the exchange rate to rise. Likewise, when domestic interest rates fall, they tend to drive away foreign investors, causing the currency to lose value on the international market.
At one point, one U.S. Dollar was worth approximately one trillion German marks. While this is an extreme example of hyperinflation, it demonstrates the point well when prices rise, the real value of money drops, decreasing spenders' purchasing power and weakening the economy. In response to this drop in domestic value, a country's currency loses worth in the international market, lowering its exchange rate. For more information on inflation in the United States, investors can learn about the Consumer Price Index (CPI) and other important factors at the Bureau of Labor Statistics.
Another major factor behind the exchange rate is interest rates. Often determined by a country's central bank or federal government, interest rates control and affect many important financial products, including mortgages, loans, credit cards and certain investments. Because higher interest rates give lenders within a country better returns relative to those in another country, they tend to attract capital from foreign investors, increasing the value of the country's currency and causing the exchange rate to rise. Likewise, when domestic interest rates fall, they tend to drive away foreign investors, causing the currency to lose value on the international market.
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