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Foreign exchange rates are influenced by internal and external factors. Internal factors can be as simple as determining whether a country has specific controls or limits on its currency. The most current example of a controlled currency is the Chinese yuan, which the Chinese government maintains in a narrow trading band. Other global currencies, especially the ones coming from emerging markets and less developed countries, also are controlled by their respective governments. External factors deal mostly with trade issues (disputes) or the market's perception of the political and economic situation in a given country. Of course, wars and natural disasters also qualify as potential market-moving events.
The most important influences on currency values are
- Interest rates: As a rule, higher interest rates lead to higher currency prices.
- Inflation rates: Higher inflation tends to lead to a weaker currency. This general rule doesn't apply when the rate of inflation is leading a country's central bank to raise interest rates. In that case, despite higher inflation, the markets are likely to bid up that country's currency as they expect interest rates there to continue to rise.
- Current account status: Countries that tend to export more than they import tend to have stronger currencies than countries that import more than they export. This relationship is soft, however, because some countries, such as Japan, purposely keep their respective currencies weak by selling them in the open market just to keep their exports high. These countries don't export their currencies; instead, their central banks sell them into the open market by making trades just like any other trading desk. The net effect is to increase the amount of a country's currency that is floating in the markets, thus decreasing its value to indirectly affect the balance of trade.
- Budget status: Countries with budget surpluses, again, as a general rule, tend to have stronger currencies than countries with budget deficits. This rule also is soft, because it doesn't hold up all the time. For example, the United States (U.S.) has chronic budget and current-account deficits, but the U.S. dollar experiences long rallies in which its strength is quite impressive.
- Political stability: Along with interest rates and economic fundamentals, politics are more than likely the most consistent determinants of the exchange rates that are quoted on a regular basis. Despite a fairly strong economy, an otherwise strong dollar during the Clinton administration suffered during the Monica Lewinsky scandal.
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