Introduction
Even though it is an integral part of all financial markets, the foreign exchange liquidity isn’t discussed very much. Foreign exchange illiquidity is still not fully understood in terms of what causes it and how it works. Foreign exchange, also called forex or FX, is trading currencies worldwide. The rate at which each coin can be exchanged depends on several things, and any good trading strategy must consider forex liquidity. Knowing all the things that can change the value of a currency can help you trade in foreign exchange more successfully. So, with that in mind, here are the seven most important reasons forex prices change. For FX trade, inflation reports are critical economic indicators. Differences in inflation are directly related to the health of a country’s economy, and the inflation rate tells investors what to expect in terms of volatility and viability.
Determinants of Exchange Rates
Remember that exchange rates are based on how the two countries’ currencies compare. Here are a few of the most important things that affect the fx liquidity between two countries. These factors are not listed in any particular order. Like many other things in economics, the relative importance of these factors is often debated.
Inflation Differences
A country with low inflation in the past usually has a currency whose value increases as its buying power increases in relation to other currencies. In the second half of the 20th century, Japan, Germany, and Switzerland were some countries with low inflation. The United States and Canada didn’t reach this low inflation until much later. Compared to their trading partners’ currencies, the value of the money of countries with higher inflation tends to go down. Most of the time, this also goes along with higher interest rates.
Differentials In Interest Rates
There is a close relationship between exchange rates, inflation, and interest rates. Central banks manage interest rates to control inflation and the liquidity provider. Changing interest rates affects both inflation and the value of currencies. When compared to other countries, economies with higher interest rates give lenders a better return. So, higher interest rates bring in investments from different countries and increase the exchange rate. But the effects of higher interest rates are lessened if the country’s inflation is much higher than that of other countries or if other things work to make the currency worth less. When interest rates go down, exchange rates tend to go up. This is the opposite of what happens when interest rates go down.
Deficits In Current Accounts
The current account is a country’s trade balance with its trading partners. It includes all payments for goods, services, interest, and dividends. A government with a negative current account balance borrows money from other countries to cover its deficit. This means that it spends more on international trade than it brings in.
Government Debt
Countries will use big deficit spending to pay for public projects and government spending. The reason? Inflation is made worse by having a lot of debt; if inflation is high, the loan will be paid back with real dollars worth less.
Conclusion
The currency’s exchange rate in which most of a portfolio’s investments are held determines its actual return. A falling exchange rate shows that income and capital gains from any returns have less money to spend. Even though forex market liquidity is controlled by several complicated factors that often confuse even the most experienced economists, investors should still know that currency values and exchange rates significantly affect the rate of return on their assets.
