The determination of a currency’s value and its exchange rates are two fundamental bases of forex trading. Expectations regarding currencies’ future value are directly influenced by several economic and political factors related to a country. If a country is perceived as politically or economically unstable, or if there is a significant possibility of hyperinflation, investors shy away from that currency and are reluctant to hold it for significant periods or in large quantities.
Beyond the perceived security of a currency, many other factors, apart from inflation, can influence the exchange rate: the GDP growth rate, the trade balance, interest rates and the level of debt. Investors monitor the main macroeconomic indicators to decide which currencies to buy or sell. There is no a predominant variable which, more than others, determines exchange rates, although the rate of inflation is certainly one of the most important. At one point, for example, interest rates may be the determining factor; at another, inflation or economic growth may be the primary factor.
We must also remember that exchange rates are always a relative variable, in the world of fiat currencies, where no currency has an intrinsic value, unlike gold. For this reason, the value of a currency depends on the perception that investors have of the value of other countries’ currencies or its domestic purchasing power. The rate of inflation is certainly a variable that contributes both to changing the purchasing power and to generating expectations. This is why traders not only observe the current inflation rate but also, and perhaps most importantly, the expected inflation rate in order to make trading decisions. Inflation differentials are also another key factor. For example, if the Eurozone has a high inflation rate, but this is lower than in the US, the relative value of the euro will be lower than that of the dollar and, therefore, the EURUSD exchange rate will decrease, because traders will expect higher interest rates in the US, and therefore they will buy more US dollars.