What is the exchange rate?

Introduction

The exchange rate is the price at which you can exchange a currency against another. Basically, if fruits were currencies and 2 bananas cost the same than 3 strawberries, the exchange rate would be 1 banana = 1.5 Strawberries.

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What does the exchange rate depends on?

While there’s a lot of debate amongst economists (surprise, surprise) about what causes exchange rates to change, there is a consensus (according to Jason Van Bergen) that the following six factors are important:

  • Inflation rates: generally, countries with lower inflation rates have higher-valued currencies
  • Interest rates: higher interest rates often mean that investors get a better return in one country than another, and so sometimes push the value of a country’s currency up compared to low interest countries
  • Current account deficits: a current account deficit means that a country is spending more on foreign trade (via imports) than it is earning (via exports), and so it will need to borrow from other countries to finance its deficit – and generally this means the value of its currency will decline
  • Level of public debt: if a country is running very large budget deficits, and borrowing to cover this cost, you will often see high inflation, which in turn will often mean a lower currency valuation.
  • Terms of trade: the terms of trade means the difference between the price of exports and the price of imports – a positive terms of trade means the prices a country gets for its exports is higher than the price it pays for its imports. Generally, the stronger the terms of trade, the stronger the currency, which has definitely been affecting the Aussie dollar in recent years
  • Stability and economic growth: finally, the level of political stability, and whether an economy is growing at all, matter to investors. Stable, growing countries are lower risk, and therefore tend to have stronger currency valuations.

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