Supply and demand is the simple concept behind all price movements in the forex market and no two fundamental economic indicators are better suited to measure supply and demand than capital and trade flow. Capital flow measures the money that is flowing in and out of an economy for investment purposes. As money flows in and out of an economy the supply of demand for that economy’s currency rises and falls. This causes the value of that currency to rise and fall as well.

Just as the importing or exporting of goods shifts the supply-demand balance for a particular country so does the flow of money coming into and out of a country as a result of capital flows. The barriers to investing in foreign countries have come down as a result of the internet and other factors it is much easier for fund managers and other investors to take advantage of opportunities not only in their domestic markets, but anywhere in the world.

Trade flow is how much income the country brings in through trade and capital flow is how much foreign investment the country attracts are critical components of currency movement. The reason why it’s only the fourth influencer is that some countries are more sensitive to trade flows while others are more dependent on capital flows. In this way it’s not possible to apply the weight of trade flows and capital flows to the same country.

The flow of capital from one economy to another affects the currencies of the two economies involved in the exchange. This tells you that increasing demand for a currency increases the value of that currency. Demand for a currency increases as investors move their money from another economy into the economy represented by that currency. For example, when investors in Japan want to buy U.S. government bonds they must exchange their Japanese yen for U.S. dollars. This increases the demand for and thus the value of U.S. dollars.

There are many factors that can affect both trade and capital flows for a particular country and therefore its currency. As currency traders it is up to us to know what to expect in terms of a reaction in the forex market when various things occur. Always think of things in terms of how something affects the supply demand relationship. Once you understand this it is important to understand whether that effect fit into the trade flow or capital flow category.