Purchasing power refers to how much you can get for your money with the local currency in different countries. Purchasing power parity is how this differs between countries. It's often used as a starting point for valuing currencies because purchasing power is sometimes seen as the "true value" of a currency.
For example, if a basket of common household goods costs $100 in Australia, and an equivalent basket costs US$50 in the United States, then AUD$1 should theoretically be worth USD$2. If it's not, you can look at whether it's overvalued or undervalued as a starting point for your own currency forecast.
Interest rates are set by a country's central bank and refer to how much interest is paid on loaned money.
These interest rate changes affect inflation, consumer behaviour and international investment in a country, and other factors which all come together to change currency prices.
By itself:
- Raising interest rates generally leads to a stronger currency, as it attracts more foreign investment and demand for a country's currency.
- Lowering interest rates generally weakens a currency, as does the opposite, and reduces foreign investment.
Other factors to consider include:
- International trade. If a country exports more than it imports, the high demand for their goods is positive for its currency.
- National debt and growth. Lower national debt and more growth bolsters confidence in a country's economic future and attracts more foreign investment.
- Policy changes. Policy changes such as lowering interest rates or borrowing too much money affect a currency's value.
- Other markets. The value of a currency can be affected by other markets. For example, a booming stock market may take money from forex investments.
- Speculation. Speculative currency trading can have a stabilising and destabilising impact on exchange rates.
There are a lot of factors which determine the value of a currency, and in the short run there tends to be a lot of cyclical ups and downs. But no matter which way it's going, it's always worth getting the best rates possible.
