Forex 101: What Causes the Value of a Currency to Rise Or Fall?

While many people invest and speculate on the forex markets, they don’t always understand what may cause currency fluctuations. Understand what can affect the markets is important for making short- and long-term investment decisions.

There are many factors that can affect exchange rates. However, some factors cause greater fluctuations than others.

It is important to understand what impacts exchange rates. It’s the same as you would understand a company and industry before investing in stocks. Here are some exchange rate fluctuation factors to consider when investing.

Monetary Policy

A country’s monetary policy has to do with its central bank, or Federal Reserve in the U.S. These government agencies set policies related to economic stimulus as well as interest rates. Understanding how central banks operate can improve your forex trading strategy.

The monetary policy can also have an effect on the inflation rate. Monetary easing tends to lead to higher rates of inflation, which is not good for the overall economy.

In general, a country with a lower inflation rate will have a higher value for its currency. Many mature economies, like the U.S., U.K., and Canada, have lower inflation rates than emerging markets. Meanwhile, high inflation is related to a depreciation in a currency.

Interest rates, inflation, and exchange rates are connected, so central banks use their influence over interest rates to impact the value of a currency. The decisions can increase or decrease the rate of inflation in a country.

Higher interest rates offer higher returns for lenders. Therefore, nations with higher interest rates attract foreign investment that increases the value of the currency. However, this can be offset if the inflation rate is higher.

Political and Economic Situations

Political situations can have positive and negative effects on a currency. A stable political situation can provide stability to the forex market. A stable government is more likely to maintain relations with its trading partners.

In general, a government that is perceived as stable will have a healthier economy. A less stable political climate can cause wider fluctuations.

Instability affects not only the currency but also the stock market. It creates a lack of confidence in a country and, therefore, the currency. Investing in a currency with an unstable political situation can be risky.

The political situation is usually connected to the economic situation. A healthier economy will attract more foreign investment. This can then stabilize or increase a currency’s value.

Of course, a strong economy does not always mean a highly-valued currency. Political uncertainty, low-interest rates, and high inflation would devalue a currency even in a strong economic market.

Understand Currency Fluctuations Before You Invest

You should understand what causes currency fluctuations before you decide to invest in forex markets. This knowledge will help you to make better informed financial decisions.

As you trade on forex markets, you can check out these free forex signals to help with your investment opportunities. There is risk in any investment. And you should be aware of such risks before investing in foreign currencies as well.

This article was put together by our in-house financial experts.