How Does Inflation Affect Forex Trading?

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The cost of goods and services in most countries rises at least once a year. The increase in the general price level is called inflation. It takes place due to several reasons like unemployment, differences in the inflation rate of various countries, wages, etc. In this post, we help you understand How Does Inflation Affect Forex Trading?

forex trading
forex trading

When individuals find that prices are rising, they demand higher wages from their employers. An increased cost of production leads to an increase in price thus creating inflationary pressure on the market for goods and services. As the interest rates increase (i.e., with a decline in purchasing power), borrowing costs also increase. Consequently, investment declines, affecting economic expansion, employment opportunities, and wage negotiations, resulting in stagflation. When goods are over-traded, people will spend more than before, which will cause inflation.

This increases the cost of living, which reduces purchasing power. The value of money decreases, making people want to spend more while fewer goods and services are available.

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How Does Inflation Affect Forex Trading?

Inflation causes economic problems. In a situation of having too much money, people will spend more and buy more goods which means that demand for these products goes up. However, supply remains the same, meaning that prices have to go up as well. This is where forex comes into play.

inflation
inflation

Let’s say that you are an exporter of a product or a service, and you keep your profits in US dollars (USD). Those profits will be valued less next year as inflation increases the cost of living, thus making it difficult for local companies to pay out their employees regularly because they also experience devaluation due to inflation. As such, companies may not even want to deal with USD as payment because it loses its value over time. Making your profits worth less than before.

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Using devaluation to your gain

Forex traders are in a position to take advantage of devaluation. If you hold up the value you have earned in USD. The money will be worth more because there is high inflation in the US dollar, which devalues it. So holding your funds in another currency with relatively stable prices compared to USD can make you earn more money without even trading or by simply waiting for appreciation in foreign currencies against USD. This is how inflation affects forex trading.

devaluation
devaluation

Acknowledged experts believe that countries with high inflation rates are more susceptible to forex crises. A country is in a “currency crisis” situation when there is rapid devaluation, making its currency lose value over time. The central bank sometimes requires steps to control inflation through increased interest rates or cuts on expenditure,. Resulting in slower economic growth and increased unemployment.

Forex traders can profit from this by trading one currency for another because there is less demand for the first currency. It loses its value over time while there is more demand for the second currency, thus appreciating against the first one.

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How do Governments Drive Up Inflation?

Another cause of inflation is when the government prints money out of thin air to finance public debt and pay for its expenditures. The currency value decreases because more currency units are in circulation than an equivalent amount of goods to purchase.

how do governments drive up inflation
how do governments drive up inflation

This leads to hyperinflation, which means that prices go up quickly, and people almost instantly lose their purchasing power. When a country experiences hyperinflation, it becomes difficult for currencies to be traded on a foreign exchange market. 

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How to Protect Your Trades Against Inflation?

When inflation affects forex trading, traders should shift from buying certain currencies due to devaluation and choose others instead, which appreciate against devalued money. Traders can also shift from trading volatile assets into other safe-haven assets such as gold or silver, also considered hedges against inflation. You can ask your forex broker for more information on this.

Protect Your Trades Against Inflation
Protect Your Trades Against Inflation

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The opposite is deflation, where prices go down because of a recession or depression. When this happens, businesses reduce the prices of their goods to sell more products, thus increasing their profit margins. This means that investors can buy bonds at lower costs. And then wait for deflation to end before selling them at higher rates along with their interest earnings.

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