Currency and what influences it

By Cutcher & Neale Accounting and Financial Services - June 09, 2022

Currency is a medium of exchange for goods and services.

A currency exchange rate is one of the most important determinants of a country's relative level of economic health. Exchange rates play a vital role in a country's level of trade, which is critical to almost every free market economy in the world.

In this article we look at some factors that influence a country’s currency exchange rate.

Interest rates

Interest rates will contribute to the general strength or weakness of a currency. A country’s central bank will move rates higher or lower to either stimulate or slow down an economy. Higher interest rates impose a more costly fee to borrow money, while lower interest rates lessen the fee and usually spur more borrowing (or access to cheap credit) in an economy.

When it comes to demand for a particular currency, however, the higher the interest rate usually means the higher the demand for that currency. Lower interest rates usually decrease the demand for a currency.

Inflation

Inflation is defined by the rise in prices of goods and services. It is generally considered healthy for a country to have a moderate increase in inflation in a growing economy. Many central banks have a target inflation rate for their economy of around 2 to 3 percent a year.

When an economy sees too much inflation, the central bank will try to cool off rising prices and access to cheap credit through an increase in interest rates. In a growing economic environment, rising inflation rates will tend to increase expectations that interest rates will rise.

There are also downsides to inflation when not in unison with a growing economy, called stagflation (high unemployment, low growth, high inflation) and the dreaded deflation, which is when prices are in decline.

Economic growth

The strength of an economy enhances the strength of a country’s currency. A strong growth rate in a country generally increases the growing demand for products and services, as well as being an attractive destination for capital and investments.

A country’s economic standing is measured by its gross domestic product (GDP). A strong GDP reading is growth of 3 percent or more in many cases, while a negative reading shows an economy could be headed for a recession. A typical definition of a recession is two consecutive quarters of negative GDP growth.

More growth can bring higher inflation rates and the expectations for interest rate increases. Foreign investment and demand from companies abroad can also play an important factor in boosting the local currency of a strong economy.

Current account balance

A country’s current account balance may also impact their currency. In simple terms, it is the total amount of goods, services, income and current transfers of a country against all of its trading partners. A positive current account balance signals that a country lends more to its trading partners than it borrows, and a deficit current account balance shows that the country borrows more from its trading partners than it lends.

This total amount of trade can influence the country’s exchange rate positively if there is more demand for that country’s goods (and currency) from other countries. A deficit or borrower country will see less demand for its own local goods and currency overall.

Currency impacts on your investments

For most Australian’s a percentage of their wealth will be allocated to overseas or international investment markets. The value of these will be impacted by not only the underlying performance of the investments, but the movements in currency relative to the Australian Dollar. For example, when investing in a United States listed investment, the most favourable outcome will be when the investment increases in value and the Australian Dollar weakens against the US Dollar.

If you would like to discuss your investment options, please do not hesitate to get in touch with our team.

 

Contact us