Foreign exchange, or forex, is the conversion of one country's currency into another. In a free economy, a country's currency is valued according to the laws of supply and demand. In other words, a currency's value can be pegged to another country's currency, such as the U.S. dollar, or even to a basket of currencies. A country's currency value may also be set by the country's government.
However, many countries float their currencies freely against those of other countries, which keeps them in constant fluctuation.
Factors Affecting Currency Value
The value of any particular currency is determined by market forces based on trade, investment, tourism, and geopolitical risk. Every time a tourist visits a country, for example, they must pay for goods and services using the currency of the host country. Therefore, a tourist must exchange the currency of their home country for the local currency. Currency exchange of this kind is one of the demand factors for a particular currency.
Key Takeaways
- Foreign exchange, also known as forex, is the conversion of one country's currency into another.
- The value of any particular currency is determined by market forces related to trade, investment, tourism, and geopolitical risk.
- Foreign exchange is handled globally between banks and all transactions fall under the auspice of the Bank for International Settlements (BIS).
Another important factor of demand occurs when a foreign company seeks to do business with another in a specific country. Usually, the foreign company will have to pay in the local company's currency. At other times, it may be desirable for an investor from one country to invest in another, and that investment would have to be made in the local currency as well. All of these requirements produce a need for foreign exchange and contribute to the vast size of foreign exchange markets.
Foreign exchange is handled globally between banks and all transactions fall under the auspice of the Bank for International Settlements (BIS).
How Inflation Affects Foreign Exchange Rates
Inflation can have a major effect on the value of a country's currency and its foreign exchange rates with other currencies. While it is just one factor among many, inflationis more likely to have a significant negative effect on a currency's value andforeign exchange rate. A low rate of inflation does not guarantee a favorable exchange rate, but an extremely high inflation rate is very likely to have a negative impact.
Inflation is also closely related tointerest rates, which can influence exchange rates. The interrelationship between interest rates and inflation is complex and often difficult for currency-issuing countries to manage. Low interest rates spurconsumer spendingandeconomic growth, and generally positive influences on currency value. If consumer spending increases and demand grows to exceed supply, inflation may ensue, which is not necessarily a bad outcome. However, low interest rates don't usually attract foreign investment the way higher interest rates can. Higher interest rates attractforeign investment, which is likely to increase demand for a country's currency.
FAQs
Foreign Exchange Rate Market Supply and Demand
What are the factors affecting the foreign exchange rate? ›
Supply and demand dictate foreign exchange rates. For example, greater demand for British goods would see an increase in the value (appreciation) of the Pound. Markets worried about the future of the Eurozone economies would tend to sell Euros leading to a depreciation of the Euro.
What 3 factors affect the value of a country's currency? ›
Many factors may affect currency value, such as:
- Interest Rates. Currencies of countries offering higher interest rates tend to increase in value, all else being equal. ...
- Inflation. ...
- Capital Flow. ...
- Money Supply. ...
- Fixed Exchange Rate. ...
- Floating Exchange Rate.
Exchange rates are constantly moving, based on supply and demand.
What is the definition of foreign exchange? ›
Foreign exchange, or forex, is the conversion of one country's currency into another. In a free economy, a country's currency is valued according to the laws of supply and demand. In other words, a currency's value can be pegged to another country's currency, such as the U.S. dollar, or even to a basket of currencies.
What are the six factors that influence exchange rates? ›
9 Factors That Influence Currency Exchange Rates
- Inflation. Inflation is the relative purchasing power of a currency compared to other currencies. ...
- Interest Rates. ...
- Public Debt. ...
- Political Stability. ...
- Economic Health. ...
- Balance of Trade. ...
- Current Account Deficit. ...
- Confidence/ Speculation.
Movements in the exchange rate influence the decisions of individuals, businesses and the government. Collectively, this affects economic activity, inflation and the balance of payments. There are different ways in which exchange rates are measured.
How does the exchange rate affect the economy? ›
When exchange rates change, the prices of imported goods will change in value, including domestic products that rely on imported parts and raw materials. Exchange rates also impact investment performance, interest rates, and inflation—and can even extend to influence the job market and real estate sector.
What is the strongest currency? ›
Kuwaiti Dinar (KWD)
The Kuwaiti dinar continues to remain the highest currency in the world, owing to Kuwait's economic stability. The country's economy primarily relies on oil exports because it has one of the world's largest reserves. You should also be aware that Kuwait does not impose taxes on people working there.
What is the lowest currency in the world? ›
The Iranian Rial is considered the world's lowest currency due to factors such as economic sanctions limiting Iran's petroleum exports, which has resulted in political instability and depreciation of the currency. 2. Which currency holds the title of the highest valuation globally?
The exchange rate gives the relative value of one currency against another currency. An exchange rate GBP/USD of two, for example, indicates that one pound will buy two U.S. dollars. The U.S. dollar is the most commonly used reference currency, which means other currencies are usually quoted against the U.S. dollar.
What happens when exchange rate increases? ›
In the goods market, a positive shock to the exchange rate of the domestic currency (an unexpected appreciation) will make exports more expensive and imports less expensive. As a result, the competition from foreign markets will decrease the demand for domestic products, decreasing domestic output and price.
What is a foreign exchange example? ›
a market in which one currency is exchanged for another currency; for example, in the market for Euros, the Euro is being bought and sold, and is being paid for using another currency, such as the yen.
What are the 3 necessary characteristics of a currency? ›
They share the three functions of money:
- First: Money is a store of value. If I work today and earn 25 dollars, I can hold on to the money before I spend it because it will hold its value until tomorrow, next week, or even next year. ...
- Second: Money is a unit of account. ...
- Third: Money is a medium of exchange.
Q-Chat
- Government Intervention.
- Inflation.
- Interest Rates.
- Current Account Deficits.
- Government Debt.
- Speculation.
There are eight key factors: -
- Interest and inflation rates.
- Current account deficits.
- Government debt.
- Terms of trade.
- Economic performance.
- Recession.
- Speculation and.
- Government intervention.
