Question

Explain conditions that cause exchange rates to fluctuate. What are some effects of exchange rate fluctuation? Please post with 200+ words.

Answer 1

Foreign Exchange rate (ForEx rate) is one of the most important means through which a country’s relative level of economic health is determined. A country's foreign exchange rate provides a window to its economic stability, which is why it is constantly watched and analyzed. If you are thinking of sending or receiving money from overseas, you need to keep a keen eye on the currency exchange rates.

1. Inflation Rates

Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate than another's will see an appreciation in the value of its currency. The prices of goods and services increase at a slower rate where the inflation is low. A country with a consistently lower inflation rate exhibits a rising currency value while a country with higher inflation typically sees depreciation in its currency and is usually accompanied by higher interest rates

2. Interest Rates

Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates, and inflation are all correlated. Increases in interest rates cause a country's currency to appreciate because higher interest rates provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in exchange rates

3. Country’s Current Account / Balance of Payments

A country’s current account reflects balance of trade and earnings on foreign investment. It consists of total number of transactions including its exports, imports, debt, etc. A deficit in current account due to spending more of its currency on importing products than it is earning through sale of exports causes depreciation. Balance of payments fluctuates exchange rate of its domestic currency.

4. Government Debt

Government debt is public debt or national debt owned by the central government. A country with government debt is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their bonds in the open market if the market predicts government debt within a certain country. As a result, a decrease in the value of its exchange rate will follow.

5. Terms of Trade

Related to current accounts and balance of payments, the terms of trade is the ratio of export prices to import prices. A country's terms of trade improves if its exports prices rise at a greater rate than its imports prices. This results in higher revenue, which causes a higher demand for the country's currency and an increase in its currency's value. This results in an appreciation of exchange rate.

6. Political Stability & Performance

A country's political state and economic performance can affect its currency strength. A country with less risk for political turmoil is more attractive to foreign investors, as a result, drawing investment away from other countries with more political and economic stability. Increase in foreign capital, in turn, leads to an appreciation in the value of its domestic currency. A country with sound financial and trade policy does not give any room for uncertainty in value of its currency. But, a country prone to political confusions may see a depreciation in exchange rates.

7. Recession

When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange rate.

Currency fluctuations arise from the floating exchange rate system, which is followed by most major economies. The exchange rate of currencies against others depends on various factors such as relative supply and demand for currencies, economic growth of countries, inflation outlook, capital flows, and so on. As these factors are constantly changing, currencies fluctuate with them. The fluctuation of a country’s currency can have a far reaching impact on the country’s economy, consumers, businesses and remittance inflows. Let’s take a closer look at some of these dynamics.

The Economy

One of the most prominent impacts of currency fluctuations can be seen in international trade. Generally, a weaker currency stimulates exports and makes imports expensive, thus decreasing the country’s trade deficit in the long run. On the other hand, a strong currency can reduce exports and make imports cheaper, effectively widening the trade deficit. While it is generally assumed that a strong currency is a good thing for a nation’s economy; in reality, it might not be. An unjustifiable strong currency can cause a drag on the economy over the long term, as entire industries are rendered uncompetitive and thousands of jobs are lost. As GDP is directly linked to exports, a weaker currency may actually help the country’s economy, contrary to popular belief. On the other hand, a depreciating currency can result in inflation as the cost of importing goods increases. Currency fluctuations also have a direct impact on the monetary policy of a country, as exchange rates play a vital role in deciding exchange rates set by a country’s central bank.

The Consumer

Currency fluctuations have a significant impact on the consumer. As mentioned above, a weak currency increases the cost of imports and eventually, this cost is borne by the consumer. On the other hand, a strong currency allows consumers to buy more. This increased spending further benefits the overall economy of the country. Gas prices are also affected in a big way due to currency fluctuations. When the US dollar strengthens against other currencies, we see a dip in oil prices. To decode why that happens, it’s important to know that major oil exporting countries like Saudi Arabia have their currencies pegged to the US dollar. So, when the greenback gets stronger, so does the Saudi Riyal, making Saudi Arabia’s imports cheaper. Due to this, Saudi Arabia can afford to charge lower prices for oil. With oil prices affecting the cost of commodities worldwide, consumers can directly feel the effect of these inter-linked fluctuations.

Business

Currency fluctuations affect all kinds of businesses, but businesses that export or import supplies from other countries are most severely affected. A change in currency can have a direct impact on a business’s bottom line. Even if a business does not buy or sell to other countries, these fluctuations can have some unforeseen consequences. For instance, if a company uses trucks to move its products and a currency change fluctuates the cost of fuel, there will be a direct impact on shipping costs. On the other hand, a depreciating currency can also help domestic businesses sell more locally, by reducing the country’s imports.

International Remittances

Expats who send money back home on a regular basis, keep a constant eye on exchange rates, since they stand to benefit or loose from any fluctuation. When a country’s currency weakens, its expats in other parts of the world get more value on their money transfers; and we can see a rise in inward remittances to the country. Being a preferred money transfer brand for millions of expats around the world, Xpress Money witnesses a direct impact of these fluctuations. Some expats go to the extent of taking loans to make the most of the exchange rates. In turn, an increase in remittance inflows helps the country’s economy by enabling its citizens to spend and invest.