Question

1. Why are exchange rates so volatile and change a lot (the question is general, not specific to the recent events, in other words the question asks why the exchange rates change all the times, what are the reasons)? What are the general factors affecting the exchange rate and causing price of different currencies to change?

Answer 1

Exchange rates will be volatile when they follow the flexible regime, that is, exchange rate depends on free market forces of demand and supply of domestic and foreign currency. Ceteris paribus, exchange rate will rise (fall) when demand (supply) of domestic currency rises and will fall (rise) when demand (supply) of domestic currency falls.

General factors affecting the changes in demand and supply of domestic currency are as follows.

(i) If interest rate in home country is higher than interest rate in foreign country, home will attract more foreign investment which will increase the demand of domestic currency (and increase the supply of foreign currency), appreciating the domestic currency (depreciating foreign currency), increasing the exchange rate.

(ii) If inflation rate in home country is lower than inflation rate in foreign country, home country's exports become more competitive in global market, increasing export demand, which will increase the demand of domestic currency (and increase the supply of foreign currency), appreciating the domestic currency (depreciating foreign currency), increasing the exchange rate.

(iii) If foreign country grows faster than home country, foreign import demand for home country's goods rises, meaning home country's export demand rises, which will increase the demand of domestic currency (and increase the supply of foreign currency), appreciating the domestic currency (depreciating foreign currency), increasing the exchange rate.

(iv) If home country's investors experience a rise in investor confidence, home will attract more foreign investment which will increase the demand of domestic currency (and increase the supply of foreign currency), appreciating the domestic currency (depreciating foreign currency), increasing the exchange rate. Likewise, if home country enjoys stronger political stability than comparable foreign countries, home will attract more foreign investment which will increase the demand of domestic currency (and increase the supply of foreign currency), appreciating the domestic currency (depreciating foreign currency), increasing the exchange rate.