Bank Rates Inflation
Low inflation increases the value of a currency, whereas high inflation usually makes the value of a currency drop. If a candy bar costs $2 today, but there is 2% inflation then that same candy bar will cost $2.02 in a year. That is inflation.
Some inflation is good. It means that the economy is growing. But, high inflation is usually the result of an increase in the supply of currency without an equal growth in the real value of a country’s assets.
Think of it like this, if there is more of something then it’s usually worthless. That is why we pay so much for rare autographs and collectors’ items. With more currency in circulation, the value of that currency will drop.
Inflation results from a growing economy, this is why China, India and other emerging economies typically have high growth and high inflation and their currencies are worthless.
Zimbabwe experienced hyperinflation throughout the late 1990’s and 2000’s reaching as high as 79.6 billion percent in 2008, rendering the currency near worthless.
Bank Rates Interest rates
When the Bank of Canada (or any other central bank) raises interest rates, it is essentially offering lenders (like banks) a higher return on investment.
High-interest rates are attractive to currency investors. Because they can earn interest on the currency that they have bought. So when a central bank raises interest rates investors to flock to buy their currency, which raises the value of that currency and, in turn, boosts the economy.
A strong economy usually leads to a strong currency, while a floundering economy will result in a fall in value. This is why GDP, employment levels and other economic indicators are monitored so closely by currency traders.
But remember, no one single factor influences currency exchange. Often times a country will offer a very high-interest rate but the value of that currency will still fall. This is because despite the incentive of profiting from a high-interest rate. Traders may be wary of the economic and political risks, or other factors – and thus refrain from investing.