Factors Causing Fluctuations in Exchange Rate

Currency fluctuations are a natural outcome of floating exchange rates, which is the norm for most major economies. Numerous factors influence exchange rates, including a country’s economic performance, the outlook for inflation, interest rate differentials, capital flows and so on. A currency’s exchange rate is typically determined by the strength or weakness of the underlying economy. As such, a currency’s value can fluctuate from one moment to the next.

Factors:

Capital Movements:

International capital movements from one country for short periods to avail of the high rate of interest prevailing abroad or for long periods for the purpose of making long-term investment abroad. Any export or import of capital from one country to another will bring about a change in the rate of exchange.

Trade Movements:

Any change in imports or exports will certainly cause a change in the rate of exchange. If imports exceed exports, the demand for foreign currency rises; hence the rate of exchange moves against the country. Conversely, if exports exceed imports, the demand for domestic currency rises and the rate of exchange moves in favour of the country.

Stock Exchange Operations:

These include granting of loans, payment of interest on foreign loans, repatriation of foreign capital, purchase and sale of foreign securities which influence demand for foreign funds and through it the exchange rates.

For instance, when a loan is given by the home country to a foreign nation, the demand for foreign money increases and the rate of exchange tends to move unfavourably for the home country. But, when foreigners repay their loan, the demand for home currency exceeds its supply and the rate of exchange becomes favourable.

Banking Operations:

Banks are the major dealers in foreign exchange. They sell drafts, transfer funds, issue letters of credit, accept foreign bills of exchange, take up arbitrage, etc. These operations influence the demand for and supply of foreign exchange, and hence the exchange rates.

Speculative Transactions:

These include transactions ranging from anticipation of seasonal movements in exchange rates to the extreme one, viz., flight of capital. In periods of political uncertainty, there is heavy speculation in foreign money. There is a scramble for purchasing certain currencies and some currencies are unloaded. Thus, speculative activities bring about wide fluctuations in exchange rates.

Monetary Policy:

An expansionist monetary policy has generally an inflationary impact, while a constructionist policy tends to have a deflationary inflation. Inflation and deflation bring about a change in the internal value of money. This reflects in a similar change in the external value of money. Inflation means a rise in the domestic price level, fall in the internal purchasing power of money, and hence a fall in the exchange rate.

Political Conditions:

Political stability of a country can help very much to maintain a high exchange rate for its currency; for it attracts foreign capital which causes the foreign exchange rate to move in its favour. Political instability, on the other hand, causes a panic flight of capital from the country hence the home currency depreciates in the eyes of foreigners and consequently, its exchange value falls.