Understanding the Currency Markets Fundamentals

With all the global economic transformations, political changes, scientific breakthroughs, and social shifts that are taking place, this is one of the most exciting times to get involved in forex. Have you been thinking about what kind of knowledge, background, and financial stake it takes to start forex trading as a hobby or full-time pursuit? Many people are already doing it, and the foreign exchange markets have become a magnet for anyone who has the desire to add to their income a little or a lot.

In addition to the mechanics of learning how to place orders, find a reliable broker, choose a platform, and open an account, there are some essential facts new traders need to know. The best part is that there’s no need to have an academic degree in finance, accounting, or international trade. All it really takes to get started is a general knowledge of how the international currency markets work. Here are some core fundamentals that can serve as a solid foundation for your future self-education on the topic of forex trading and what factors influence exchange rates.

Trade Balance and Currency Strength

It’s no secret that some nations prefer to be exporters and others establish themselves as importers. The tricky part comes in how their juggle their currency strength. Put yourself into the mind of a major exporter. You would not want to have a particularly strong currency. If you did, your international buyers would pay dearly for your goods and services. However, if your money is weak compared to theirs, they’ll be more able to spend huge amounts acquiring your goods. Pay close attention to whether the nations that interest you as a trader are net exporters or net importers. This kind of information is easy to find in financial media publications and on brokerage website knowledge bases.

Meddling by Central Banks

Central banks, meaning government banking institutions, like the Bank of Japan or the U.S. Federal Reserve, are notorious for tweaking, manipulating, and otherwise messing with the value of their nation’s denominational currency. This sort of unannounced interference takes place most often in centrally controlled, communist-socialist economies. The Chinese yuan, for instance, is much more susceptible to unforeseen devaluations and revaluations than the Mexican peso or the U.S. dollar. Open societies in which leaders are freely elected by citizens tend to see much less central bank manipulation than nations run by dictators. When you trade, notice how much easier it is to find honest, transparent reports about free nations’ economies than it is to gather data on totalitarian states like China, Cuba, or South Africa.

Fiscal Policies and Inflation Targets

The U.S. is a concrete example of a nation that sets regular fiscal policies that include things like inflation targets, employment goals, and labor laws. For forex traders, these sorts of political controls can influence the value of the dollar (for the U.S.) against other national money denominations.

Purchasing Power Parity and Big Mac

If one dollar, based on international exchange rates, is said to be worth exactly one Canadian dollar, it would be logical to think that a specific consumer good in Toronto would cost the same as it does in New York City. An index that was begun as a humorous attempt at explaining this principle has become a good way to estimate purchasing-power parity, or PPP. What if, in the example above, a Big Mac hamburger was priced at $2 in the U.S. but $4 in Canada. That wouldn’t make sense if the U.S. and Canadian dollars were trading 1:1 at the time. Based on analysis derived from the Big Mac Index, we would say that those hamburgers in Canada are priced way too high.

Forex enthusiasts can use the Big Mac Index to guide their decision-making. But, because the BMI is just a rough estimate, don’t make it your primary way of evaluating dollars, yen, yuans, or anything else. What it is good at doing is offering a warning signal that two related currencies are out of kilter with each other based on their stated rate of exchange. As with all other technical indicators, proceed with caution, but make note of what the numbers are saying. Understanding the fundamentals of how national and global economic systems work is an important part of becoming a successful trader. That’s why it pays to spend time reading and leaning about the general topic so you can fully realize the many factors that cause a given nation’s currency value to rise and fall.

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