Factors that Determine Currency Exchange Rates
Currency exchange rates do not necessarily represent reflections of the health or productivity of a nation. Instead, exchange rates are determined by supply and demand forces generated by businesses, governments, financial institutions, central banks, and individuals participating in the foreign exchange market. Below, is the list of the factors that have the most significant influence on exchange rate changes.
Changes in Relative International Price Levels: Changes in relative international prices impact a nation’s importing and exporting levels. If for example, Canada’s prices rise faster than prices in the United States, these relatively higher prices in Canada would reduce the demand for Canadian goods and services by U.S. residents, thereby reducing the demand for Canadian dollars. At the same time, higher relative prices in Canada and a stronger Canadian dollar relative to the U.S. dollar might increase their demand for U.S. imports and U.S. dollars.
Changes in Relative International Real Gross Domestic Product (GDP): If Canada’s real GDP rises relative to the U.S., the ability of Canadian residents to purchase U.S. goods and services rises, resulting in an increased demand for U.S. dollars and a relative decrease in the Canadian dollar.
Changes in Relative International Interest Rates/ Investment Returns: Any time a nation lowers its interest rates relative to the interest rates of another nation, the money flows between the two nations is impacted. A relative reduction in Canadian interest rates compared to the U.S., for example, would cause U.S. investors to decrease their demand for Canadian dollars. This decreased demand would cause the relative value of the Canadian dollar to fall.
Changes in Relative International Risks, Taxes, and Expectations: An increase in one Canada’s taxes or risks relative to those factors in the U.S. will cause a decrease in demand for Canadian dollars by U.S. residents. In fact, any speculation regarding these factors will impact exchange rates.
Changes in Central Bank Intervention: A nation’s central bank will often work to influence the relative value of its currency to the benefit of its economy. As an example, if the U.S. Federal Reserve sees benefit in raising the value of the U.S. dollar relative to the Canadian dollar, it would take actions to decrease the relative supply of U.S. dollars.
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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