An exchange rate is how much of a given nation’s currency you can buy with a different nation’s currency. If you purchase foreign goods or travel abroad, you may need to convert your currency to another country’s money.
Why do exchange rates fluctuate?
Exchange rates are a critical measure of a country’s financial health, and they constantly shift as the demand for a particular currency increases or decreases.
Many factors go into determining exchange rates and can cause them to change. For instance, a currency’s value might go up or down due to international trading, policy decisions, investor expectations, the political climate, and the overall economic conditions of the home country.
9 common causes of exchange rate fluctuations
Pinpointing what causes exchange rates to change isn’t straightforward. Even the most accomplished economists sometimes struggle because of how often exchange rates change and the many interrelated factors involved.
There are two main types of exchange rates—fixed and floating. In a fixed exchange rate system, a government or central money maintains a currency’s value, allowing little to no fluctuation. In contrast, floating exchange rates are based on current supply and demand forces within the foreign market.
Many things affect the supply and demand of a currency (and thus its value), including inflation, interest rates, stock market performance, and government debt.
Let’s dive into nine reasons why exchange rates change.
1. Inflation
Inflation occurs when the cost of goods and services increases, decreasing the purchasing power (and actual value) of a currency.
Typically, the perceived value of the money will decrease as well, deterring investors from buying it. As the currency loses its buying power and becomes less attractive in the foreign market, the exchange rate will likely drop in favor of stronger currencies.
2. Interest rates
Interest rates play a major role in a currency’s value and are an essential part of a country’s monetary policy. Governments often adjust interest rates to manage inflation and economic growth, which can push a nation’s exchange rate higher.
For example, a government will often raise interest rates in a high-inflation economy, discouraging borrowing and encouraging saving. Over time, prices for goods and services drop, enticing consumers to start buying again. This typically causes the currency to appreciate, resulting in a higher foreign exchange rate.
3. Recession
A country is in a recession when its gross domestic product (GDP), the total market value of all final goods and services produced within its borders, drops for two consecutive quarters. Often marked by high unemployment, a recession causes everyone to pinch pennies, including foreign investors.
When a nation’s economy is weak, its currency loses international appeal. As a result, the exchange rate will typically drop until the country’s financial situation improves.
4. Speculation
As investors try to earn a profit, their speculation on a currency’s value could cause the exchange rate to change.
Suppose investors believe a nation’s money is overvalued. They might sell their holdings to cash out before an anticipated dip, potentially driving down the currency’s value. On the other hand, if investors think a currency is undervalued, they may go on a buying spree that causes an artificial price hike.
5. Stock markets
The performance of a nation’s stock market is a significant indicator of its financial health and, thus, a potential cause of exchange rate fluctuations.
Stocks outperforming investor expectations is a sign of a strong economy. This makes a currency more appealing to foreign investors. Conversely, an underperforming stock market might drive foreign investors away from a currency.
6. Political instability
When a country’s economy is unstable, its money typically loses value on the international stage. Political instability often leads to the same result.
Political unrest and division create uncertainty, potentially discouraging foreign investors from investing in that country’s currency or businesses. Political instability can also drive up inflation, disrupt production and exports, and force governments to spend more. This combination can hurt a currency’s value.
7. Current account deficits
A current account measures the money coming in and out from selling goods and services to other countries. The current account has a deficit if the nation imports more than it exports and borrows foreign currency to operate and grow.
While a current account deficit can benefit a country, it could eventually cause the nation’s money to lose value. Foreign investors may pull back if they don’t predict a high enough return on their investment, ultimately resulting in a lower exchange rate.
8. Terms of trade
Terms of trade (TOT) measures the ratio between a nation’s export and import prices. When export prices increase faster than import prices, the country’s revenue goes up, as does the demand for the nation’s currency. As more people want to buy the currency, the value increases.
When import prices increase faster than export prices, the opposite happens. The country’s revenue, currency demand, and exchange rate decrease.
9. Government debt
Governments sometimes take on debt to fund national improvements. However, too much debt might make a country’s currency less attractive to foreign investors.
Investors might speculate about the country’s ability to repay its debt, potentially leading to high inflation or a weaker currency. A poor credit rating can add to those concerns.
FAQs
What are the causes of fluctuating exchange rates?
There are many causes of exchange rate fluctuations. Generally, exchange rates change when a country experiences economic or political shifts.
What are the factors affecting the exchange rate?
Factors that affect the exchange rate include but aren’t limited to economic standing, speculation, stock market performance, political stability, current account status, terms of trade, and government debt.
Is it better for the exchange rate to go up or down?
Generally, it’s better when the exchange rate for your nation’s currency goes up because it indicates a strong economy. However, another country’s currency losing value can be an opportunity to purchase an investment that may appreciate in the future.
