Exchange rates are important to governments and the population as a whole because they affect the prices of goods and services. A currency’s exchange rate directly impacts the final costs of importing materials, closing international trades, and economic strength from the market point of view. Several factors, including a government’s monetary and economic policies and spending behavior, influence the value of its currency and the exchange rate in the forex market.

Understanding Exchange Rate

An exchange rate refers to the rate at which one unit of a currency is exchanged for another currency relative to other currencies. Fluctuating exchange rates provide the basis for forex trading and the opportunity for currency buyers and sellers to meet their needs in a regulated marketplace. The exchange rate of a currency usually fluctuates as it is influenced by various economic factors, such as inflation, government debt and spending, interest rates (monetary policy), and political stability.

There are three types of exchange rate systems: floating, fixed, and hybrid (managed).

• The Floating System: This system allows exchange rates to fluctuate based on factors influencing the demand and supply of the currency without direct government intervention. It is widely used due to the advantages of a competitive market.
• The Fixed Exchange Rate: This system allows governments to peg the value of their currency to another major currency, such as the U.S. Dollar (USD) or a basket of currencies. The central bank directly manages the pegged currency through interventions.
• The Hybrid Exchange Rate: A mix of floating rates and government interventions where the currency is allowed to float but the central bank intervenes to stabilize the value.

Measuring Exchange Rates

Exchange rates are typically measured in three methods: bilateral, cross, and trade-weighted index (TWI) rates.

• Bilateral Exchange Rates: This is the most common way to measure an exchange rate. It refers to the relative value of two currencies, one to another. In the bilateral method, currencies are usually measured (quoted) against the USD, which is the world’s most traded currency and reserve. This is why all major currency pairs have the USD as the base or quote.
• Cross Exchange Rates: This method measures the exchange rate of one currency to another by referencing a third currency (called the cross). Cross rates have the advantage of bypassing the USD and provide analysts with better insights into the underlying conditions of individual currencies.
• Trade-Weighted Index Exchange Rates: The TWI method measures the value of a currency relative to a basket of currencies, weighted based on the importance of each currency. TWI rates provide more insights into a country’s currency performance and trade flows. They do not fluctuate as much as bilateral rates but are often considered a better way to appreciate the factors influencing the forex market.

Among all the factors that influence exchange rates, government spending and policy decisions have the most significance because they influence other areas of the economy.

Overview of Government Investments and Spending

The federal government is responsible for creating and implementing the annual budget, which accounts for all investments and spending it will undertake in the year. The government’s fiscal policy determines the general direction of the economy; investors know to look at a government’s early moves to know how safe it is to invest in the economy.

The U.S. Congress, empowered by the Constitution, can create the federal budget, subject to the President’s approval for the fiscal year. The budget spells out, in clear terms, the amounts set aside for mandatory and discretionary spending, investments, and emergencies. It is important to note that most governments generate revenue primarily from taxes and borrowing to fund their budgets.

All government spendings are categorized as either mandatory or discretionary and are geared towards economic growth, job creation, competitiveness, and stability. The government’s spending is on goods, services, and programs that serve the economy and residents of the country, ensuring the nation’s well-being and development at all levels.

These are the five core areas that governments spend on:

1. Infrastructure Investments: Governments spend on building infrastructure for roads, bridges, public transport systems, airports, national defense, communication, and other areas that serve as the primary structures on which other areas of the economy are built. These investments ensure that the nation has a solid base for enhancing productivity and efficiency and can attract foreign direct investment (FDI) while supporting local investments. The higher the quality of a country’s infrastructure, the more robust its economy will likely be.

2. Research and Development (R&D): R&D investments and culture drive technological advancements and innovations across all sectors. R&D investments include research grants and other programs targeting research in various settings. The result is usually the discovery and creation of technologies that improve the quality of life and promote economic growth, and countries with strong currencies have a corresponding growth of technology from research.

3. Healthcare and Social Programs: These improve the quality of life and the overall productivity of the nation’s workforce. Investments in healthcare, social security, and other programs reduce the costs of illness and productivity, allowing countries to scale their revenue and economic strength. Positive health outcomes are a useful indicator of economic health that investors track.

4. Environmental Investments: Governments also invest in the environment to promote sustainability and protect natural and man-made assets. These days, the buzz around green practices is taking center stage in global discussions as the world grapples with the increasing effects of global warming. Environmental investments help ensure that economic strides can last longer and lead to the emergence of other sectors.

5. Education and Workforce Development: The government also invests in education and scholarships to discover, attract, and nurture local and foreign talents. These investments target enhanced skills and productivity in the workforce, leading to a stronger and more competitive economy.

The U.S. government’s mandatory, discretionary, and supplemental spending runs to trillions annually and has been between 20% to 23% of the GDP since 2015. The spending-to-GDP ratio puts a perspective on the government’s financial activities and the impact on the economy. Higher spending-to-GDP ratios may signal waning economic strength and higher inflation. The U.S. government’s spending reached $5.02 trillion in the 2024 fiscal year (October 2023 to June 2024), showing a marked increase from the $4.81 trillion in the 2023 fiscal year.

How Government Investments Affect Exchange Rates

Government investments and spending influence the exchange rate in various ways, ranging from the trade balance to controlling inflation through monetary policy.

• Trade Balance: The balance of trade is an important factor impacting the productivity and competitiveness of a country’s economy. A country with a stronger export sector can command a stronger currency in the marketplace as its foreign trades are completed using the domestic currency. Government investments in local industries and policies that promote robust exports can create a stronger economy with stronger exchange rates.

• Increased GDP and Economic Strength: Government investments in various aspects of the economy also improve economic strength and GDP. The GDP impacts the exchange rate in the long term by influencing the demand for the currency. High-GDP countries attract investors who consider economic growth to be potentially profitable for their investments. High GDP also allows governments to take higher loans to invest in their economies.

• Investor Confidence: Government policies, investments, and spending influence investors’ confidence and are a major factor that local and foreign businesses consider when planning their investments. Governments that prioritize spending that bolsters the economy and successfully implement positive policies can attract investors and increase the demand for the currency, thereby driving exchange rates higher.

• Inflation and Interest Rates: Monetary policy is the primary tool that governments use to control inflation. The Federal Reserve, the U.S. apex bank, targets a 2% inflation rate and adjusts the interest rate in that direction. Investors expect the Fed to cut interest rates in August to head off recession. Higher interest rates attract investors looking for higher returns, thereby stimulating economic growth and a higher exchange rate. Sustained interest rate hikes are effective in combating inflation but may worsen the economy if not properly handled, hence the regular rate cuts. The Jerome Powell-led board considers factors such as inflation and employment figures during policy meetings.

The Influence of Political and Economic Stability on Exchange Rates

Political and economic policies play important roles in maintaining the stability of any country. A politically stable country is ideal for foreign investors and projects the right international image. The U.S., for instance, is considered the world’s largest economy and haven currency; this is why the USD is the most traded currency and attracts investments when markets are uncertain. With a strong and stable internal business and political situation, the GDP can grow and maintain its growth for longer periods, leading to fewer fluctuations in exchange rates.

The USD has endured several losses this year but has bounced back repeatedly, showing promise of a stronger long-term trend. Investors expect a choppy market as the U.S. goes into the election season later in the year, and post-election performance will be key to unlocking foreign investments in the U.S.

How Government Spending Shapes Economic Strength and Exchange Rates

How a government chooses to spend its money plays a key role in maintaining a healthy economy and keeping the currency strong in the global market. Prudent government spending will help boost productivity and attract investors, leading to a stronger currency and more stable exchange rates.