When you look at trading the foreign exchange rates you will see that they are constantly changing.  It is important that you know what affects the foreign exchange rates and cause these fluctuations.  When you know about these factors you can trade better on the market as you understand the movements in price action.  It is important that you understand that the foreign exchange rates are directly linked to the supply and demand of a currency.

There are two main factors that affect the supply and demand of the currency.  These factors are the interest rates and the economic growth.  It is important that you understand how these factors affect the foreign exchange rate.  When you know about this you can understand the ways that you should be trading.

Interest Rates and Foreign Exchange Rates

If you wish to borrow money from your financial institution, the interest that you will be charged is based on the interest rates that the central bank of your country determines.  When a country’s economy is under-performing, the central may decide to lower the interest rates in the hope that borrowing will increase. 

The lowering of the rates is often enough to increase spending by the consumers and this will aid in revitalising the economy.  If the economy boost is too much, the central bank will normally increase the benchmark interest rate as this will cause the borrowing rate to be increased and become an expensive option.

This up and downswing of interest rates particularly affects investors who are simply trying to reach a balance between the returns they achieve and the safety of their money.  When interest rates go up, the yields of assets that are held in that particular currency will increase as well.  The demand for the currency will increase and its value will be increased.  In the event that the interest rates decrease, most investors will be loath to accept a fall in their yield.

Economic Growth and Foreign Exchange Rates

In countries where they are experiencing a growth in their population, the country has to make sure that its economy is expanded to meet the need of the people.  The one problem is that if the growth occurs too quickly, it could lead to problems.  This action will cause the wage increases to fall behind the price increases.  This will cause a dip in the buying power of the consumers even if they receive wage increases. 

Most countries target a percentage of 2 as ideal for their yearly economic growth.  Higher growth will cause higher inflation.  When this happens the central bank will step in and raise interest to increase the borrowing costs in an attempt to curb the spending level in the market.  As soon as the central bank changes the interest rates, there is bound to be a change in the forex rates.

The opposite of inflation, known as deflation, occurs when a country is experiencing a recession and is evidence that the economy is in a state of stagnation.  If this happens, the central bank will lower the interest rates in an attempt to boost consumer spending.  This is done with a view to reversing the deflation.

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